Chapter

Business
Combinations
Introduction
In the previous chapter, we pointed out that a corporation can obtain a subsidiary
either by establishing a new corporation (a parent-founded subsidiary) or by buy-
ing an existing corporation (through a business combination). We also demon-
strated the preparation of consolidated financial statements for a parent-founded
subsidiary.
When a subsidiary is purchased in a business combination, the consolidation
process becomes significantly more complicated. The purpose of this chapter is to
explore the meaning and the broad accounting implications of business combina-
tions. First, we will examine the general meaning of business combination, which
can mean a purchase of assets as well as a purchase of a subsidiary. Next, we will
look more closely at the issues surrounding purchase of a subsidiary and at con-
solidation at the date of acquisition. The procedures for consolidating a purchased
subsidiary subsequent to acquisition are the primary focus of Chapters 4 to 7.

Definition of a Business Combination

A business combination occurs when one corporation obtains control of a group
of net assets that constitutes a going concern. A key word is control—control can
be obtained either by:
1. buying the assets themselves (which automatically gives control to the buyer),
or
2. buying control over the corporation that owns the assets (which makes the
purchased corporation a subsidiary).

A second key aspect of the definition of a business combination is that the

purchaser acquires control over “net assets that constitute a business” [ED
1980.03]1—i.e., a going concern. Purchasing a group of idle assets is not a busi-
ness combination.
A third aspect is the phrase net assets—net assets means assets minus liabili-
ties. Business combinations often (but not always) require the buyer to assume
some or all of the seller’s liabilities. When the purchase is accomplished by buy-
ing control over another corporation, liabilities are automatically part of the
package. But when the purchaser buys a group of assets separately, there may or
may not be liabilities attached, such as when one corporation sells an operating
division to another company. In any discussion of business combinations,
remember that net assets includes any related liabilities.

1. “ED” refers to the September 1999 CICA Exposure Draft on business combinations.
 Finally, observe that business combination is not synonymous with consolida-
tion. As we discussed in the previous chapter, consolidated financial statements
are prepared for a parent and its subsidiaries. The subsidiaries may be either par-
ent-founded or purchased. A purchased subsidiary usually is the result of a busi-
ness combination. But sometimes one corporation will buy control over a shell
corporation or a defunct corporation. Since the acquired company is not an oper-
ating business, no business combination has occurred.
As well, not all business combinations result in a parent-subsidiary relation-
ship. When a business combination is a direct purchase of net assets, the acquired
assets and liabilities are recorded directly on the books of the acquirer, as we shall
discuss shortly.

Chapter Accounting for Business Combinations—General

Three
Approach
78
The general approach to accounting for business combinations, whether (1) a
direct purchase of net assets or (2) a purchase of control, is a three-step process:
1. Measure the cost of the purchase
2. Determine the fair values of the assets and liabilities acquired
3. Allocate the cost on the basis of the fair values

The mechanics of accounting for the acquisition will depend on the nature of
the purchase, particularly on whether the purchase was of the net assets directly or
of control over the net assets through acquisition of shares of the company that
owns the assets. Let’s look at the general features that apply to all business com-
binations before we worry about the acquisition method used.

Measuring the cost

The acquirer may pay for the assets (1) in cash or other assets, (2) by issuing its
own shares as consideration for the net assets acquired, or (3) by using a combi-
nation of cash and shares.
When the purchase is by cash, it is not difficult to determine the total cost of
the net assets acquired. When the purchase is paid for with other assets, the cost
is measured by the fair value of the assets surrendered in exchange.
One of the most common methods of acquiring the net assets of another
company is for the acquirer to issue its own shares in full or partial payment for
the net assets acquired. When shares are issued as consideration for the purchase,
the cost of the purchase is the value of the shares issued. If the acquirer is a pub-
lic company, then the valuation of the shares issued is based on the market value
of the existing shares.
Note that although the valuation of the shares issued is based on the market
value, the value assigned to the newly issued shares may not actually be the mar-
ket price on the date of acquisition. The value assigned to the issued shares is more
likely to reflect an average price for a period (e.g., 60 days) surrounding the pub-
lic announcement of the business combination. The CICA Handbook suggests, for
example, that the value of shares issued should be “based on the market price of
the shares over a reasonable period of time before and after the date the terms of
the acquisition are agreed to and announced” [ED 1580.18]. Notice the use of the
words based and reasonable, both of which are subject to professional judgement.
 The assigned value may be further decreased to allow for the under-pricing
that is necessary for a new issue of shares. Nevertheless, the value eventually
assigned to shares issued by a public company normally will bear a proximate
relationship to the value of the shares in the public marketplace.
Exceptions to the use of market values do still arise, even when a public mar-
ket value exists. The CICA Handbook suggests that the fair value of the net assets
acquired could be used instead of the value of the shares issued if “the quoted
market price is not indicative of the fair value of the shares issued, or the fair value
of the shares issued is not otherwise clearly evident” [ED 1580.18]. Again, notice
the use of the judgemental words not indicative and clearly evident.
A business combination, whether paid for by assets or by shares, may include
a provision for contingent consideration. Contingent consideration is an add-on
to the base price that is determined some time after the deal is finalized. The
amount of contingent consideration can be based on a number of factors, such as: Business

• a fuller assessment of the finances and operations of the acquired company, Combinations

• the outcome of renegotiating agreements with debt holders, 79

• achievement of stated earnings objectives in accounting periods following the
change of control, or
• achievement of a target market price for the acquirer’s shares by a specified
future date.

Contingent consideration that is paid in future periods usually is considered

to be additional compensation. The treatment of additional compensation varies:
• If the additional future amount can be estimated at the time that the business
combination takes place, the estimate is included in the original calculation
of the cost of the purchase [ED 1580.20].
• If the amount cannot be estimated at the date of the combination but addi-
tional compensation is paid in the future, the fair value of the net assets is
adjusted (usually by increasing the amount of goodwill attributed to the pur-
chase) [ED 1580.23].
• If additional shares are issued because the market price of the issued shares
falls below a target price (or fails to reach a target price in the future), the
additional shares do not represent an additional cost, but simply the issuance
of more shares to maintain the same purchase price [ED 1580.24].

Valuation of shares issued by a private company is even more judgemental. If

it is not feasible to place a reliable value on the shares issued, it will instead be
necessary to rely upon the fair value of the net assets acquired in order to meas-
ure the cost of the purchase. In practice, the fair values assigned to the acquired
assets and liabilities in a purchase by a private corporation often are remarkably
similar to their recorded book values on the books of the acquiree.
There is a lot of room for the exercise of professional judgement in deter-
mining the cost of an acquisition.

Determining fair values

Guidelines for determining fair values of net assets are outlined in the CICA
Handbook [ED 1580.38]. In general, the recommended approaches are:
1. Net realizable value for assets held for sale or conversion into cash
 2. Replacement cost for productive assets such as raw materials and tangible cap-
ital assets
3. Appraisal values for intangible capital assets, land, natural resources, and non-
marketable securities
4. Market value for liabilities, discounted at the current market rate of interest

These guidelines are completely consistent with International Accounting

Standards and the newly issued standard in the U.S.A. However, they are only
guidelines. Furthermore, it should be apparent that fair value measurements are
accounting estimates. The fair values are judgemental combinations of different
methods of valuation—a bit of a hodgepodge, really. There is a great deal of lat-
itude for management to exercise judgement in determining these values. As we
Chapter shall explain in the next chapter, such judgement can have significant conse-
Three
quences for reporting in future periods.
Fair values should be determined for all identifiable assets (and liabilities)
80 acquired, whether or not they appear on the balance sheet of the selling company.
The basket of acquired assets may include valuable trademarks, patents, or copy-
rights, none of which may be reflected on the seller’s books. Similarly, unrealized
tax benefits (that is, the benefits from tax loss carryforwards) may also accrue to
the purchaser; these too should be valued.
One type of asset and/or liability that is not given a fair value is any future
income tax amounts that appear on the selling company’s balance sheet.2 These
are not assets and liabilities from the standpoint of the buyer, since they relate
solely to the differences between tax bases and accounting carrying values on the
books of the acquired company.
We don’t escape the complications of income tax allocation, however. Future
income tax accounting is a factor in the purchaser’s financial reporting for pur-
chased subsidiaries. Acquiring companies must determine their own future
income tax balances based on the difference between the asset and liability values
they show on their consolidated financial statements and the tax bases. Future
income tax considerations tend to confuse students who are trying to understand
the sufficiently complex issues in business combinations and consolidations.
Therefore, we have decided to treat future income tax aspects separately in an
appendix to this chapter (as well as in an appendix to Chapter 4).

Allocating the cost

The third step in accounting for a business combination is to allocate the cost. It is
a generally accepted principle of accounting that when a company acquires a group
of assets for a single price, the total cost of the assets acquired is allocated to the
individual assets on the basis of their fair market values. If a company buys land and
a building for a lump sum, for example, the land and building are recorded at their
proportionate cost, as determined by estimates of their fair values.
The same general principle applies to assets and liabilities acquired in a busi-
ness combination. The total cost of the purchase is allocated on the basis of the
fair market values of the assets and liabilities acquired.
However, the price paid for the operating unit will be determined in part by
its earnings ability. The acquirer may or may not choose to continue to operate the
unit in the same manner; but regardless of the acquirer’s plans, the price to be paid
will take into account the acquired unit’s estimated future net revenue stream.
2. This refers to the results of the interperiod income tax allocation process, sometimes known as deferred
income tax accounting. Any current taxes receivable or payable are assigned a fair value.
 If the unit has been successful and has demonstrated an ability to generate
above-average earnings, then the acquirer will have to pay a price that is higher
than the aggregate fair value of the net assets. On the other hand, if the unit has
not been successful, the price may be less than the fair value of the net assets (but
not normally less than the liquidating value of the net assets including tax effects).
The difference between the fair value of the net assets (assets less liabilities
assumed) and the acquisition cost is known as goodwill when the acquisition
cost is higher than the fair value of the net assets, and as negative goodwill when
the cost is less.
Goodwill acquired in a purchase of net assets is recorded on the acquirer’s
books, along with the fair values of the other assets and liabilities acquired. It is
important to understand that goodwill is a purchased asset. The purchaser paid
good money (or shares) for the goodwill just as surely as for buildings and inven-
tory. In some circles (and in some countries), goodwill is called a “nothing,” Business
which derives from the fact that it does not represent any specific asset, either tan- Combinations
gible or intangible. But the fact that we can’t point at an object (for a tangible
asset) or a specific right (for an intangible or financial asset) does not make its 81
cost any less real.
Negative goodwill, however, is not recorded as such. Instead, the costs
assigned to the non-financial assets are reduced until the total of the costs allo-
cated to the individual assets and liabilities is equal to the total purchase price of
the acquired net assets. If there still is negative goodwill left over after the fair
value of the non-financial assets has been written down to zero, the excess is
reported as an extraordinary item.3
The allocation process, therefore, is essentially a two-step process:
1. acquisition cost is allocated to the fair values of the net assets acquired, and
2. any excess of acquisition cost over the aggregate fair value is viewed as goodwill.

Illustration of Direct Purchase of Net Assets

To illustrate the accounting for a direct purchase of net assets, assume that on
December 31, 2001, Purchase Ltd. (Purchase) acquires all of the assets and lia-
bilities of Target Ltd. (Target) by issuing 40,000 Purchase common shares to
Target. Before the transaction, Purchase had 160,000 common shares outstand-
ing. After the transaction, 200,000 Purchase shares are outstanding, of which
Target owns 20%. The pre-transaction balance sheets of both companies are
shown in Exhibit 3-1.
The estimated fair values of Target’s assets and liabilities are shown at the bot-
tom of Exhibit 3-1. Their aggregate fair value is $1,100,000. If we assume that the
market value of Purchase’s shares is $30 each, then the total cost of the acquisition
is $1,200,000. The transaction will be recorded on the books of Purchase as follows:
Cash and receivables 200,000
Inventory 50,000
Land 400,000
Buildings and equipment 550,000
Goodwill 100,000
Accounts payable 100,000
Common shares 1,200,000

3. Negative goodwill is discussed more fully at the end of this chapter.

 EXHIBIT 3–1 PRE-TRANSACTION BALANCE SHEETS
December 31, 2001
Purchase Ltd. Target Ltd.
Cash $1,000,000 $50,000
Accounts receivable 2,000,000 150,000
Inventory 200,000 50,000
Land 1,000,000 300,000
Buildings and equipment 3,000,000 500,000
Accumulated depreciation `(1,200,000) `(150,000)
Total assets $6,000,000 $900,000
Accounts payable $1,000,000 $100,000
Chapter
Long-term notes payable 400,000 —
Three Common shares* 2,600,000 200,000
Retained earnings ~2,000,000 ~600,000
82
Total liabilities and shareholders’ equity $6,000,000 $900,000
* for Purchase Ltd.—160,000 shares outstanding

Fair values of Target Ltd.’s net assets:

Cash $50,000
Accounts receivable 150,000
Inventory 50,000
Land 400,000
Buildings and equipment 550,000
Accounts payable ````(100,000)
Total $1,100,000

The selling company, Target, will record the transaction by writing off all of
its assets and liabilities and entering the new asset of Purchase’s shares, recogniz-
ing a gain of $400,000 on the transaction.
The post-transaction balance sheets for the two companies will appear as
shown in Exhibit 3-2. Purchase’s assets and liabilities increase by the amount of
the fair values of the acquired assets and by the purchased goodwill, while Target’s
previous net assets have been replaced by its sole remaining asset, the shares in
Purchase. If the transaction had been for cash instead of Purchase shares, Target’s
sole remaining asset would have been the cash received.
The purchase of Target’s net assets by Purchase is a business combination, but
it is not an intercorporate investment by Purchase because Purchase is not invest-
ing in the shares of Target. Since Purchase is acquiring the assets and liabilities
directly instead of indirectly through the purchase of Target shares, Purchase
records the assets and liabilities directly on its books and there is no need for con-
solidated statements; Target is not a subsidiary of Purchase.
After the net asset purchase has been recorded, Purchase Ltd. will account for
the assets as they would any new assets. There is no special treatment required.
 EXHIBIT 3–2 POST-TRANSACTION BALANCE SHEETS
December 31, 2001
Purchase Ltd. Target Ltd.
Cash $1,050,000 $ —
Accounts receivable 2,150,000 —
Inventory 250,000 —
Land 1,400,000 —
Buildings and equipment 3,550,000 —
Accumulated depreciation (1,200,000) —
Goodwill 100,000
Investment in Purchase Ltd. shares ~~~~~~``— ~1,200,000
Total assets $7,300,000 $1,200,000 Business

Accounts payable $1,100,000 $ — Combinations

Long-term notes payable 400,000 —

83
Common shares* 3,800,000 200,000
Retained earnings ~2,000,000 ~1,000,000
Total liabilities and shareholders’ equity $7,300,000 $1,200,000
* for Purchase Ltd.—200,000 shares outstanding

Purchase of Shares
Reasons for purchasing shares
Buying the assets (or net assets) of another company is one way to accomplish a
business combination. However, a much more common method of acquiring
control over the assets of another company is to buy the voting shares of the other
business. If one company buys a controlling block of the shares of another com-
pany, then control over the assets has been achieved, and the acquirer has a new
subsidiary.
An acquirer can obtain a controlling share interest by any one or a combina-
tion of three methods:
• buying sufficient shares on the open market,
• entering into private sale agreements with major shareholders, or
• issuing a public tender offer to buy the shares.

Regardless of the purchase method used, the acquirer purchases shares already
outstanding. The transaction is with the existing shareholders, not with the tar-
get company. The buyer does not need the co-operation of the acquired company
itself. Sometimes the target company’s board of directors opposes a takeover
attempt and tries to persuade the shareholders not to sell their shares to the
acquirer—this is known as a hostile takeover. Nevertheless, if the purchaser can
convince enough of the target company’s shareholders to sell their shares, a busi-
ness combination will occur.
Unlike a direct purchase of assets, a business combination that is achieved by an
acquisition of shares does not have any impact on the asset and equity structure of
 the acquired company.4 The acquired company continues to carry its assets and
liabilities on its own books. The purchaser has acquired control over the assets, but
has not acquired the assets themselves.
Purchase of shares rather than assets has the obvious advantage that control
can be obtained by buying considerably less than 100% of the shares. Control
can be obtained at substantially less cost than would be the case if the acquirer
purchased the assets directly.
There are several other advantages to buying shares rather than the net assets
themselves:
• The shares may be selling at a price on the market that is less than the fair
value per share (or even book value per share) of the net assets. The acquirer
can therefore obtain control over the assets at a lower price than could be
negotiated for the assets themselves.
Chapter

Three
• By buying shares rather than assets, the acquirer ends up with an asset that is
more easily saleable than the assets themselves, in case the acquirer later
84 decides to divest itself of the acquired business, or a portion thereof.
• The acquirer may prefer to retain the newly acquired business as a separate
entity for legal, tax, and business reasons. The acquired business’s liabilities
need not be assumed directly, and there is no interruption of the business
relationships built up by the acquired corporation.
• Income tax impacts can be a major factor in the choice between purchasing
assets and purchasing shares. A purchase of shares may benefit the seller
because any gain to the seller on a sale of shares will be taxed as a capital gain.
However, if the assets are sold, gains may be subject to tax at full rates, such
as (1) CCA (capital cost allowance) recapture, (2) a sale of inventory, or (3) a
sale of intangibles that were fully deducted for tax purposes when paid for ini-
tially. Also, the acquired company may have substantial tax loss carryfor-
wards, the benefits of which are unlikely to be realized. The purchaser may be
able to take advantage of these carryforwards.

For the buyer, however, a purchase of assets may be more desirable than a pur-
chase of shares from a tax viewpoint. When the assets are purchased directly, their
cost to the acquiring company becomes the basis for their tax treatment. For
example, depreciable assets are recorded on the acquiring company’s books at fair
values, and CCA will be based on those fair values. Similarly, goodwill purchased
is treated as eligible capital property for tax purposes and 75% of the goodwill is
subject to CCA (the other 25% is not deductible).
If control over the assets is obtained via a share purchase, on the other hand,
there is no change in the tax basis for the assets because there is no change in the
assets’ ownership. Thus the buyer cannot take advantage of any increased tax
shields if net assets are purchased at fair values that are greater than book values.
Another advantage of buying control over another company is that the
acquirer does not automatically assume the contingent liabilities of the target
company, such as lawsuits or environmental liabilities. If large unexpected liabil-
ities arise, the controlling company can let the subsidiary go bankrupt—the par-
ent loses its investment, but that’s better than being pulled down by
overwhelming liabilities.

4. An exception occurs when “push-down” accounting is used. We will discuss this concept towards the end
of the chapter.
 Obviously, the decision on acquisition method is subject to many variables.
In a friendly takeover, the method of purchase and the purchase price are subject
to negotiation, taking into account the various factors affecting both parties,
including income tax. If the takeover is hostile, then a purchase of shares is the
only alternative.
The share acquisition can be accomplished by paying cash or other assets, or
by issuing new shares of the acquirer, or by some combination thereof. When the
acquirer issues new shares as consideration for the shares of an acquired business,
the transaction is frequently called an exchange of shares. When there is an
exchange of shares, it is important to keep track of who owns which shares, in
order to determine who exercises control over whom.

Share exchanges
Business
There are many different ways in which shares can be exchanged in order to
Combinations
accomplish a business combination. Some of the more common and straightfor-
ward methods include the following: 85
• The acquirer issues new shares to the shareholders of the acquired company
in exchange for the shares of the target company (the acquiree).
• Subsidiaries of the acquirer issue shares in exchange for the acquiree’s shares.
• A new corporation is formed; the new corporation issues shares to the share-
holders of both the acquirer and the acquiree in exchange for the outstanding
shares of both companies.
• The shareholders of the two corporations agree to a statutory amalgamation.
• The acquiree issues new shares to the shareholders of the acquirer in exchange
for the acquirer’s outstanding shares.

The first method listed above is the most common approach. The acquirer
ends up having more shares outstanding in the hands of shareholders, while the
acquiree’s shares that were previously held by external shareholders are now held
by the acquirer. Both corporations continue to exist as separate legal entities, but
the acquirer’s shareholder base has been expanded to include shareholders who
had previously been shareholders of the acquiree. The acquiree does not hold any
shares in the acquirer; it is the former shareholders of the acquiree who hold the
newly issued acquirer shares.
The second approach is similar to the first, except that the acquirer does not
issue its own shares to acquire the company directly. Instead, the acquirer obtains
indirect control by having its subsidiaries issue new shares to acquire the com-
pany. This approach is useful when the acquirer does not want to alter the own-
ership percentages of the existing shareholders by issuance of additional shares.
For example, if the controlling shareholder of the acquirer owns 51% of the
acquirer’s shares, the issuance of additional shares would decrease the controlling
shareholder’s interest to below 50%, and control could be lost. But if the acquirer
has a subsidiary that is, say, 70% owned, quite a number of additional shares
could be issued by the subsidiary without jeopardizing the parent’s control.
Under the third method, a new company is created that will hold the shares
of both the other combining companies. The holding company issues its new
shares in exchange for the shares of both of the acquiree and the acquirer. After
the exchange, the shares of both operating companies are held by the holding
company, while the shares of the holding company are held by the former share-
holders of both the acquiree and the acquirer.
 In a statutory amalgamation, the shareholders of the two corporations
approve the combination or amalgamation of the two companies into a single
surviving corporation. Statutory amalgamations are governed by the provincial or
federal corporations acts under which the companies are incorporated. For two
corporations to amalgamate, they must be incorporated under the same act. The
shareholders of the combined company are the former shareholders of the two
combining companies.
Statutory amalgamation is the only method of combination wherein the
combining companies cease to exist as separate legal entities. It is also the only
method of share exchange in which the assets of both companies end up being
recorded on the books of one company, similar to the recording of assets in a
direct purchase of net assets. In all other forms of share exchange, there is no
transfer of assets and thus no recording of the acquiree’s assets on the acquirer’s
Chapter
books—the results of the combination are reported by means of consolidated
financial statements, as we discussed in the previous chapter. In contrast, consol-
Three
idated statements are not needed for the combined companies after a statutory
86
amalgamation because only one company survives. Of course, if either amalga-
mating company had subsidiaries, it would still be necessary to prepare consoli-
dated statements that include those subsidiaries.
The foregoing four methods of combination all specify one corporation as the
acquirer. The acquirer is defined as the corporation “that obtains control over the
other entity” [ED 1580.10]. It is possible to arrange the combination in such a
way that the company that legally appears to be the acquirer is, in substance, the
acquiree (the fifth method).
For example, suppose that LesserLimited has 100,000 shares outstanding
before the combination, and issues 200,000 new shares to acquire all of
GreaterCorp’s shares. LesserLimited will own all of the shares of GreaterCorp and
thus will legally control GreaterCorp. However, two-thirds of the shares of
LesserLimited will be owned by the former shareholders of GreaterCorp, and the
former shareholders of GreaterCorp will have voting control of LesserLimited
after the combination. The substance of the combination is that control resides
with GreaterCorp’s shareholders even though the legal form of the combination
is that LesserLimited acquired GreaterCorp. This form of business combination
is called a reverse takeover.
After a reverse takeover occurs, the consolidated financial statements will be
issued under the name of the legal parent (in this example, LesserLimited) but
should reflect the substance of the combination as a continuation of the financial
statements of the legal subsidiary (i.e., GreaterCorp). Pre-combination compara-
tive statements and historical data should be those of the legal subsidiary (and in-
substance acquirer) rather than of the legal parent (and in-substance acquiree).
Because of the potential confusion from reporting the substance of the activities
of the legal subsidiary under the name of the legal parent, it is common for reverse
takeovers to be accompanied by a company name change so that the name of the
legal parent becomes almost indistinguishable from that of the legal subsidiary.
An example of a reverse takeover is the 1999 acquisition of Allied Hotel
Properties by King George Development Corporation. King George acquired
100% of the shares of Allied by issuing King George shares. After the share
exchange, the former shareholders of Allied owned a majority of the shares of
King George. In the 1999 annual report, the consolidated financial statements
after the acquisition reflect the fair values of King George and the book values of
Allied. After the combination, the name of King George Development
Corporation was changed to Allied Hotel Properties Inc.5
5. For additional details, the post-consolidation financial statements of Allied Hotel Properties Inc. (i.e., the
new name) can be accessed through SEDAR.com.
 One of the main reasons for a reverse takeover is to acquire a stock exchange
listing. If LesserLimited had a Toronto Stock Exchange (TSE) listing and
GreaterCorp wanted one, a reverse takeover can be arranged instead of going to
the trouble and expense of applying to the Ontario Securities Commission (OSC)
and the TSE for a listing. In some instances, the legal acquirer (and in-substance
acquiree) is just a shell company that has an exchange listing but no assets.
The accounting problem in any business combination is to report in accor-
dance with the substance of the combination, and not to be misled by its legal
form. Accountants must be sensitive to the objectives of managers and owners in
arranging business combinations, and must examine the end result in order to
determine who purchased what and for how much.6

Illustration of a share exchange

Business
To illustrate the acquirer’s accounting for a purchase of shares, assume that on
Combinations
December 31, 2001, Purchase Ltd. acquires all of the outstanding shares of
Target Ltd. by issuing 40,000 Purchase shares with a market value of $30, or 87
$1,200,000 total, in exchange.7 After the exchange of shares, all of the Target
shares will be held by the corporate entity of Purchase, while the newly issued
shares of Purchase will be held by the former shareholders of Target and not by
Target as a corporate entity. Target will have no shareholders external to the com-
bined entity, while the shareholder base and the number of shares outstanding for
Purchase have increased.
When Purchase acquires the shares, the entry to record the purchase on the
books of Purchase will be as follows:
Investment in Target 1,200,000
Common shares 1,200,000

There will be no entry on Target’s books, because Target is not a party to the
transaction; the transaction is with the shareholders of Target and not with the
company itself. After the original purchase is recorded, the investment is
accounted for on Purchase’s books by either the cost or equity method, as dis-
cussed in Chapter 2.
Exhibit 3-3 shows the balance sheets of Purchase and Target on December 31,
2001, both before and after the purchase of Target’s shares by Purchase. The
pre-transaction amounts are the same as were shown in Exhibit 3-1, when
Purchase purchased the net assets of Target.
The post-transaction amounts on Purchase’s separate-entity balance sheet dif-
fer from the pre-transaction amounts only in one respect—Purchase now has an
account, “Investment in Target Ltd.,” that reflects the cost of buying Target’s
shares, offset by an equal increase in Purchase’s common share account. The pur-
chase price was $1,200,000, determined by the value of the 40,000 Purchase com-
mon shares given to Target’s shareholders in exchange for their shares in Target.
Target’s balance sheet is completely unaffected by the exchange of shares.
Target’s owner has changed, but nothing has changed in the company’s accounts.
Target’s net asset book value was $800,000 prior to the change of ownership, and
remains $800,000 after the change of ownership.

6. A detailed description of reverse takeover accounting is beyond the scope of this book. The Emerging
Issues Committee issued abstract EIC-10 in January 1990, “Reverse Takeover Accounting,” which deals with
many of the issues that arise when attempting to account for reverse takeovers.
7. This transaction has the same value as the illustration used earlier in the chapter for a direct purchase of
net assets.
 EXHIBIT 3–3 BALANCE SHEETS, DECEMBER 31, 2001
Before the exchange After the exchange
of shares of shares
Purchase Ltd. Target Ltd. Purchase Ltd. Target Ltd.
Cash $1,000,000 $ 50,000 $1,000,000 $ 50,000
Accounts receivable 2,000,000 150,000 2,000,000 150,000
Inventory 200,000 50,000 200,000 50,000
Land 1,000,000 300,000 1,000,000 300,000
Buildings and equipment 3,000,000 500,000 3,000,000 500,000
Accumulated depreciation (1,200,000) (150,000) (1,200,000) (150,000)
Investment in Target Ltd. `````````~`— `````````— ~1,200,000 `````````—
Chapter
Total assets $6,000,000 $900,000 $7,200,000 $900,000

Three Accounts payable $1,000,000 $100,000 $1,000,000 $100,000

Long-term notes payable 400,000 — 400,000 —
88 Common shares* 2,600,000 200,000 3,800,000 200,000
Retained earnings ~2,000,000 ~600,000 ~2,000,000 ~600,000
Total liabilities and share equity $6,000,000 $900,000 $7,200,000 $900,000
*For Purchase Ltd., 160,000 shares before the exchange; 200,000 shares after the exchange.

Target is now a subsidiary of Purchase, and therefore Purchase will prepare

consolidated financial statements for public reporting purposes. The preparation
of consolidated statements for a purchased subsidiary is somewhat more complex
than for parent-founded subsidiaries, and involves choices from among several
optional approaches. Consolidation of a purchased subsidiary at the date of
acquisition will be illustrated shortly.

Alternative Approaches to Reporting Business

Combinations
Overview
In Chapter 2, we demonstrated the preparation of consolidated statements for
Parco. To obtain the Parco consolidated balance sheet, we simply added the bal-
ances of Subco’s assets and liabilities to those of Parco, after eliminating the inter-
company balances. It might seem logical to use the same procedure to prepare
Purchase’s consolidated balance sheet, adding the book values of the two compa-
nies’ assets and liabilities together to get the consolidated amounts.
However, in Chapter 2 we were demonstrating consolidation of a
parent-founded subsidiary. In wholly-owned parent-founded subsidiaries, the car-
rying values of the subsidiary’s net assets represent the cost of the assets to the
consolidated economic entity, because it was the parent’s initial investment (and
subsequent non-withdrawal of earnings) that provided the equity to purchase the
assets. When a subsidiary is purchased, however, the purchase price of the net
assets acquired will almost certainly be different from the carrying value of those
assets on the subsidiary’s books.
Target has net assets with a book value of $800,000. Purchase issued shares
worth $1,200,000 to acquire control over Target’s net assets. The $400,000 dif-
ference between the purchase price and the book value of the net assets acquired
is known as the purchase price discrepancy. Any method of combining the bal-
ance sheets of the two companies must find a way of disposing of the $400,000
difference.
Three general alternative approaches are available for combining the balance
sheets of Purchase and Target in order to obtain a consolidated balance sheet for
Purchase. These alternatives are:
1. Add together the book values of the assets and liabilities of the two compa-
nies (the pooling-of-interests method).
2. Add the fair values of Target’s assets and liabilities at the date of acquisition
to the book values of Purchase’s assets and liabilities (the purchase method).
3. Add the fair values of Target’s assets and liabilities to the fair values of
Business
Purchase’s assets and liabilities (the new-entity method).
Combinations
The two variables that determine the results are (1) the valuation of the par-
ent’s net assets and (2) the valuation of the subsidiary’s net assets. The alternatives 89
can be summarized as follows:
Net assets of Net assets
Method parent company of subsidiary
Pooling of interests Book value Book value
Purchase Book value Fair value
New entity Fair value Fair value

To demonstrate the alternatives, we need to know the fair values of the two
companies’ net assets. Exhibit 3-4 compares each company’s book values with its
assumed fair values. To keep this example simple, we assume that only the capi-
tal assets have fair values that are different from book values. The capital assets are
highlighted in Exhibit 3-4.

Pooling of interests
Pooling of interests certainly is the simplest method of consolidating a purchased
subsidiary. Under this method, the book values of the parent and the subsidiary
are added together and reported on the parent’s consolidated balance sheet.

EXHIBIT 3–4 BOOK VALUES AND FAIR VALUES, DECEMBER 31, 2001
[Dr/(Cr)]
Purchase Ltd. Target Ltd.
Book value Fair value Book value Fair value
Cash $ 1,000,000 $ 1,000,000 $ 50,000 $ 50,000
Accounts receivable 2,000,000 2,000,000 150,000 150,000
Inventory 200,000 200,000 50,000 50,000
Land 1,000,000 2,000,000 300,000 400,000
Buildings and equipment 3,000,000 2,300,000 500,000 550,000
Accumulated depreciation (1,200,000) — (150,000) —
Accounts payable (1,000,000) (1,000,000) (100,000) (100,000)
Long-term notes payable ~`~(400,000) ~`~(400,000) `~~~~~`— ~~~~~~`—
Net assets $`4,600,000 $`6,100,000 $`800,000 $1,100,000
 The assumption underlying the pooling method is that the combined eco-
nomic entity is a continuation under common ownership of two previously sep-
arate going concerns, and that the operations of both companies will continue
without substantial change. If the companies continue to function as separate
entities—although now under common ownership—then it is presumed that
there should be no change in the basis of accountability for the assets and liabil-
ities as a result of the combination.
If we consolidate the net assets of the two companies at book values, then a
problem remains: what should we do with the $400,000 purchase price discrepancy
(i.e., $1,200,000 purchase price minus Target’s $800,000 net asset book value)?
The theoretically correct approach in pooling is to carry forward on the con-
solidated statements the pre-acquisition combined shareholders’ equity of the two
companies. That means we add Target’s common shares and retained earnings to
Chapter those of Purchase prior to the purchase—the amounts shown in the first two
Three
columns of Exhibit 3-3. The first column of Exhibit 3-5 shows the result.
The consolidated (pooled) shareholders’ equity is $5,400,000, as compared to
90 Purchase’s unconsolidated shareholders’ equity of $5,800,000 after the combina-
tion. The $400,000 difference is offset against the investment account upon con-
solidation, thereby completely eliminating the $1,200,000 investment account.
The difficulty with applying this approach is that corporations acts in Canada
generally state that corporations must record and report issued shares at their cur-
rent cash equivalent at the date of issue. For example, Article 25 of the Canada
Business Corporations Act provides that “a share shall not be issued until the con-
sideration for the share is fully paid in money or in property or past service that
is not less in value than the fair equivalent of the money that the corporation would
have received if the share had been issued for money” (emphasis added). Article 26
states that “a corporation shall add to the appropriate stated capital account the

EXHIBIT 3–5 ALTERNATIVE APPROACHES TO CONSOLIDATED STATEMENTS FOR A BUSINESS

COMBINATION
Purchase Ltd.
Consolidated Balance Sheet
December 31, 2001
Pooling Purchase New Entity
Cash $ 1,050,000 $ 1,050,000 $1,050,000
Accounts receivable 2,150,000 2,150,000 2,150,000
Inventory 250,000 250,000 250,000
Land 1,300,000 1,400,000 2,400,000
Buildings and equipment 3,500,000 3,550,000 2,850,000
Accumulated depreciation (1,350,000) (1,200,000) —
Goodwill ~~~```````— `````100,000 ~~`100,000
Total assets $`6,900,000 $`7,300,000 $8,800,000
Accounts payable $ 1,100,000 $ 1,100,000 $1,100,000
Long-term notes payable 400,000 400,000 400,000
Common shares* 2,800,000 3,800,000 3,800,000
Add’l paid-in capital: Reappraisal surplus — — 1,500,000
Retained earnings ```2,600,000 ```2,000,000 ``2,000,000
Total liabilities and share equity $`6,900,000 $`7,300,000 $8,800,000
*200,000 shares issued and outstanding
full amount of any consideration it receives for any shares it issues.” If the
Purchase shares were worth $1,200,000 at the date of their issue, then it would
be in contravention of the Act to report the shares at only $800,000 on the con-
solidated financial statements. Therefore, the Purchase shareholders’ equity can-
not legally be reduced to $5,400,000 for consolidated reporting; the full
$5,800,000 must be reported.
While there is a technical legal impediment to application of the
pooling-of-interests approach in many instances of corporate combination, there
can be combinations that would satisfy the legal requirements, as when shares are
issued whose market value approximates the book value of the shares acquired.
Also, pooling is easily applied to private companies, where there is no market value
for the shares and therefore no readily measurable current cash equivalent. Finally,
the fact is that there is no effective enforcement mechanism in the corporations
acts short of the extreme remedy of withdrawing the corporation’s legal charter. Business

Combinations
Purchase method
91
The purpose of Purchase’s purchase of Target’s common shares was to obtain con-
trol over the net assets and the operations of Target. The control obtained by a
purchase of shares is essentially the same as by purchasing Target’s net assets
directly. If Purchase had purchased the net assets, Purchase clearly would have
recorded the acquired net assets at their fair values. If the price paid exceeded the
total fair value, the excess would be assigned to goodwill.
The purchase of shares achieves the same result, as does the direct purchase
of assets. Therefore, the objective of the purchase method of consolidation is to
report the results of the purchase of shares as though the assets had been acquired
directly. The fair values of the subsidiary’s assets and liabilities are added to those
of the parent (at book value), because the fair value is considered to be the cost
of the assets and liabilities to the acquirer. Any excess of the purchase price over
the aggregate fair value is assigned to goodwill.
The allocation of the purchase price discrepancy was illustrated earlier, when
we assumed that Purchase bought Target’s net assets directly. The same calcula-
tion applies when the method of combining is an exchange of shares. The fair
value of Target’s net assets is $1,100,000. The purchase price was $1,200,000.
The difference of $100,000 between the purchase price and the net asset fair
value is attributed to Goodwill.
The second column of Exhibit 3-5 shows Purchase’s consolidated balance
sheet under the purchase method. Note that the purchase-method consolidated
balance sheet is exactly the same as the post-transaction balance sheet for direct
purchase of the assets as shown in Exhibit 3-2.

New-entity method
The purchase method has been criticized because the consolidated balance sheet
contains a mixture of old book values (for Purchase’s assets) and date-of-
acquisition fair values (for Target’s assets). One can argue that when a business
combination occurs, a new economic entity is formed, and that a new basis of
accountability should be established for all of the assets.
Under the new-entity approach, the assets and liabilities of Purchase are reval-
ued to fair value, so that the consolidated balance sheet will disclose the current
fair values (on the date of the combination) of all of the assets for the combined
entity. The third column of Exhibit 3-5 shows Purchase’s consolidated balance
sheet under the new-entity method.
 Notice that a new account has appeared in the new-entity column: “reap-
praisal surplus.” We have written up the carrying values of Purchase Ltd.’s assets,
and we need an offsetting account to credit. Any upward asset revaluation is
reflected in shareholders’ equity, as a part of paid-in capital. This is true any time
that an asset is written up, whether as a part of a business combination or because
assets are carried at fair value instead of cost.
Under certain circumstances, there is merit in the arguments for the
new-entity method. If the combining enterprises are of roughly comparable size,
and if the operations of the newly combined enterprises are going to be substan-
tially different from the predecessor operations, then a case can be made for estab-
lishing a new basis of accountability.
However, there are significant practical problems in implementing the
method. Obtaining fair values for all of the assets is likely to be an expensive and
Chapter time-consuming project, unless the acquiring company already uses current val-
Three
ues for internal reporting purposes. In addition, a substantial degree of subjectiv-
ity would inevitably exist in the fair-value determination.
92 While subjective estimates are required to assign the purchase price of a sub-
sidiary to the subsidiary’s specific assets and liabilities, the total of the fair values
assigned is limited by the total purchase price paid by the parent. But in revalu-
ing the parent’s assets for application of the new-entity method, there is no veri-
fiable upper limit for the fair values because no transaction has occurred. In
addition, the measurement of goodwill for the parent corporation would be
highly subjective. Since it is not clear how the new-entity method would improve
the decisions of users of the consolidated financial statements, it has not been
accepted in practice.

Other approaches
In the past, approaches to consolidation other than the three discussed above
have been used in practice. One of the more common was to value the transac-
tion at the fair value of the consideration given, as in a purchase, but to consoli-
date the subsidiary’s assets and liabilities at their book values, as under pooling.
The difference between the book value and the purchase price would be assigned
to goodwill on the consolidated statements.
This approach, sometimes called the carrying-value purchase method, has the
same net impact on the acquirer’s net assets as the fair-value purchase method.
However, the assignment of the entire excess of the purchase price over net book
value to goodwill can have a significant impact on consolidated earnings subse-
quent to the acquisition, because amortization of goodwill will most likely be dif-
ferent in impact than would subsequent reporting of the fair values of specific
assets and liabilities.

Purchase vs. pooling

Before leaving our discussion of the alternative methods of consolidation, we
should consider further the use of the purchase method as opposed to the pool-
ing-of-interests method.
In most business combinations, one company clearly is acquiring the other.
The acquirer is the company whose pre-combination shareholders have a major-
ity of the voting shares in the combined enterprise, regardless of which company
is legally acquiring the shares of the other. If one company can be identified as
the acquirer, then there is widespread agreement that the purchase method
should be used.
 An acquirer can always be identified when the purchase of shares is for cash,
notes, or other assets of the acquirer. In such an acquisition, the former share-
holders of the acquiree have no stake in the combined venture, and clearly they
are not pooling their interests with those of the acquirer’s shareholders. An
exchange of shares must occur for the possibility of pooling even to arise.
Consolidated financial statements can be drastically affected by the choice of
pooling or purchase accounting. The consolidated asset values usually will differ
considerably, especially for tangible and intangible capital assets. Goodwill that is
reported under the purchase method is not shown under pooling. The difference
in the asset values will have a consequent impact on earnings measurement
because the amounts of amortization will be different.
Another important difference between purchase and pooling is that pooling
is applied retroactively, while the purchase method is applied only from the date
of the purchase. Under pooling, the two enterprises are reported as though they Business
had always been combined. The comparative financial statements and other Combinations
financial information (such as earnings per share, total assets, total sales, and so
forth) are restated for the periods prior to the combination in order to reflect the 93
operations of both companies. Under the purchase method, however, there is no
restatement of prior years’ results. The business combination is viewed as any
other investment by the acquiring company, and the acquired company’s operat-
ing results are reflected in the acquirer’s operating results only from the date of
acquisition.
The difference in reporting can have an impact not only on the size of earn-
ings, but also the comparative direction over time. Pooling could cause post-
combination earnings per share (EPS) to increase, relative to pre-combination
earnings, while purchase accounting could cause EPS to decrease. The reverse sit-
uation could also occur.
The difference in results is not something that external financial statement
users can adjust for. If pooling is used, there is no way to know what the reported
results would have been under purchase accounting—there is no information
available to the public about the fair values of the net assets acquired. When
information on measurements under different accounting methods does not
exist, the market cannot adjust for the differences.
Due to the significant differences between reported results under the two
methods, there has long been a controversy about the use of pooling versus pur-
chase. This controversy has now been resolved firmly in favour of purchase, as we
shall discuss in the next section.

Current Canadian practice

Purchase method
The recommendation of the Business Combinations exposure draft is clear: “The
purchase method should be used to account for all business combinations” [ED
1580.08]. This recommendation is intended to slam the door on the use of pool-
ing by public companies.
Pooling was never widespread in Canada. Indeed, around the world, pooling
was in widespread use only in the United States. Other countries either prohib-
ited pooling or restricted its use to very narrow circumstances. The CICA
Handbook, for example, previously stated that pooling could be used only when
an acquirer could not be identified. As we will discuss more fully in a later section,
the change in Canada to prohibit pooling was basically part of a multi-country
strategy to help the Financial Accounting Standards Board (FASB) to prohibit
pooling in the United States.
 Identifying the acquirer
The acquirer in a business combination is the corporation whose shareholders
control the combined economic entity. When the purchase is for cash (or other
assets), it is obvious that the acquirer is the company that pays to acquire the
other (or the assets of the other). When the combination is effected by an
exchange of shares, the acquirer may not be so obvious.
The corporation that issues the shares is usually, but not always, the acquirer.
Earlier in this chapter, we discussed the issue of control and the fact that some
business combinations are reverse takeovers. Therefore, it is necessary to examine
which shareholder group has control of the combined economic entity in order
to determine who is the acquirer.
Voting control may appear to be evenly split between the shareholders of the
two combining companies. If that is the case, other factors must be examined to
Chapter determine who is the acquirer [ED 1580.12]. Examples of other factors include:
Three • the existence of major voting blocks,
94 • special voting rights for some shareholders, or voting restrictions on others,
• holdings of convertible debt securities and other options or derivatives,
• the composition of the board of directors, and
• the composition of the senior management team.

Corporate restructurings—non-arm’s-length pooling

The AcSB’s purchase method recommendation does not apply to combinations of
companies under common control [ED 1580.02]. The CICA Handbook cites
three examples that relate to transfers between subsidiaries or between a parent and
its existing or newly-formed subsidiaries. The exemption of transfers between enti-
ties under common control also would apply to corporations that are not in a par-
ent-subsidiary relationship, but that have a common controlling shareholder.
A shifting of assets among companies under common control is often called a
corporate restructuring. A parent company (or its owners) may decide to
rearrange the intercorporate ownerships of the economic entity comprised of the
parent and its several subsidiaries. New subsidiaries may be formed, or parts of the
economic entity may be combined or otherwise regrouped or redefined. When a
corporate restructuring takes place, there is no arm’s-length transaction because all
of the legal corporations are ultimately controlled by the same shareholders. Since
there is no arm’s-length transaction, the assets cannot be revalued for reporting on
either the separate-entity or the consolidated financial statements.
Voluntary restructurings of corporate ownerships are quite common in both
public and private companies in Canada. Since corporate ownership restructur-
ings are accounted for as though they were poolings of interest, it is necessary to
understand the pooling method even though it is not widely used for business
combinations reported by public companies.8

International Practices for Business Combinations

In general, countries around the world have required that the purchase method
be used for business combinations. Pooling has been permitted in many coun-
8. The relevance of pooling for combinations by private companies is another matter, however. These will be
discussed in a later section of this chapter, “Acquisitions by private companies.”
tries, such as Canada and the U.K., if an acquirer cannot be determined. The one
big exception to the general application of the purchase method has been,
throughout the last half of the twentieth century, the United States. The U.S.A.
has been the most enthusiastic pooler in the world, by far.
In contrast, Australia and New Zealand banned the use of pooling altogether;
only purchase accounting has been permitted. Although it may, in some
instances, be difficult to establish which company among equals is the acquirer,
“experience with the Australian standard suggests that any difficulties in identify-
ing the acquirer are not insurmountable.”9
Originally, there were absolutely no restrictions on the use of pooling in the
United States. Pooling could be used for any business combination, regardless of
the relative size and power of the combining companies. Pooling could even be
used when the purchase was for cash, with no continuing share ownership by the
previous shareholders of the target company. Business
In 1970, the AICPA’s Accounting Principles Board tried to rein in the use of Combinations
pooling by imposing a set of 12 criteria that would govern whether the transac-
tion should be accounted for as a purchase or by pooling.10 Given the radically 95
different reported results that can be obtained under pooling, it was hardly sur-
prising that many U.S. acquirers structured their purchase transactions in a way
that would then require them to use their preferred method of accounting.11
The result of the use of pooling was that “two economically similar business
combinations can be accounted for using different accounting methods that pro-
duce dramatically different financial results.”12 A further consequence was that
companies that could not use pooling (such as Canadian companies that were
competing for acquisitions) felt that they were severely disadvantaged by lower
reported earnings that may be caused by their inability to use pooling. Some
observers felt that companies that could use pooling were able to pay more for a
target acquisition than a company that could not use pooling. Therefore, “hav-
ing two accounting methods that produce dramatically different results affect
competition in markets for mergers and acquisitions.”13
In 1999, the standard setters of Canada, Australia, New Zealand, the U.K.,
and the U.S. (i.e., the “G4” countries) co-operated on the issuance of new stan-
dards to eliminate the use of pooling. Effectively, the only country whose stan-
dards were seriously changed by the new proposals was the U.S.A. The new
standards will achieve international harmonization on a major issue in accounting.
International Accounting Standard 22, Business Combinations, is in agree-
ment with the new harmonized standard of the G4. However, it does still permit
the pooling of interests method, known as “uniting of interests.” It is quite pos-
sible that the IASC will eliminate this alternative in a future amendment of the
standard.

9. Methods of Accounting for Business Combinations: Recommendations of the G4+1 for Achieving
Convergence, paragraph 75. Published simultaneously by the standard setting bodies of Canada, U.S.A., U.K.,
Australia and New Zealand, December 1998.
10. APB Opinion 16, issued in 1970. The Accounting Principles Board, or APB, was the standard-setting body in
the U.S. prior to establishment of the FASB in 1971.
11. This should be a familiar scenario. It is similar to companies’ approach to lease transactions—decide how they
want the lease to be reported (i.e., capital or operating), and then structure the lease contract accordingly.
12. Edmund L. Jenkins, FASB Chairman, in testimony before the U.S. Senate Committee on Banking, Housing,
and Urban Affairs, March 2, 2000; quoted in the FASB Status Report of March 24, 2000.
13. Ibid.
 Consolidation Procedures
Exhibit 3-5 illustrated the purchase-method consolidated statements in the sec-
ond column. We explained that the amounts in that column were obtained by
adding the book value of each of Purchase’s assets and liabilities to the fair values
of Target’s.
Before plunging into the greater complexities of consolidation in the follow-
ing chapters, we will more carefully illustrate the general procedure for consoli-
dating subsidiaries that were acquired through a business combination. The key
factor that differentiates the procedure is that, for business combinations, con-
solidation mechanics must adjust for fair values. Fair values are not an issue for
parent-founded subsidiaries.

Chapter Direct method

Three
After one company acquires control over another, each company will still con-
96 tinue to prepare its own separate-entity financial statements. Remember that each
company is still a legal and operating entity. Consolidated statements are an arti-
ficial construct of the accounting profession—artificial in that there is no legal
entity that corresponds to the economic entity of the parent and its subsidiaries.
But the reporting objective is substance over form. Although the parent and its
subsidiaries are separate legal entities and prepare separate, individual financial
statements, the overall economic entity is the group of companies. For that reason,
consolidated statements are called group accounts in most parts of the world,
even though there are no formal group accounts—just consolidation working
papers and statements.
In theory, purchase accounting combines the book values of the parent with
the fair values (at date of acquisition) of the purchased subsidiaries. In practice,
consolidation actually begins with book values of both companies. At date of
acquisition, it is clear that the book values and the fair values relate to the same
assets and liabilities. As time moves on, however, assets will enter and leave the
balance sheet of each purchased subsidiary, and the asset base will change.
Therefore, consolidation takes the book values of both companies and adds
the fair value increments relating to the assets of Target that existed when Target
was acquired. The fair value increments (or decrements) are the differences
between Target’s book values and fair values at the date of acquisition.
An analysis of the purchase price is illustrated in Exhibit 3-6. Of the
$1,200,000 purchase price, $800,000 is attributed to the book value of the net
assets acquired, $300,000 is the total of the fair value increments, and the resid-
ual $100,000 is attributed to goodwill. On a continuing basis, consolidated net
assets will be computed as:
• book value of each asset and liability,
• plus any fair value increments (or minus any fair value decrements) relating
to assets still on Target’s books from the date of consolidation,
• plus goodwill, if any.

Exhibit 3-7 (page 98) shows the derivation of Purchase’s consolidated balance
sheet at December 31, 2001, using the direct method. For each item on the bal-
ance sheet, we take the book value for Purchase, add the book value of Target,
and add the fair value increment. The fair value increment (and goodwill) adjust-
ments are indicated with a “b.” Also, we must eliminate Purchase’s investment
account and Target’s shareholders’ equity accounts (indicated with an “a”). The
EXHIBIT 3–6 ALLOCATION OF PURCHASE PRICE
100% Purchase of Target Ltd., December 31, 2001
Purchase price $1,200,000
Fair Fair value % FVI
Book value value increment share acquired
Cash $50,000 $50,000 —
Accounts receivable 150,000 150,000 —
Inventory 50,000 50,000 —
Land 300,000 400,000 $100,000 × 100% = $100,000
Buildings and equipment 500,000 550,000 50,000 × 100% = 50,000
Accumulated depreciation (150,000) — 150,000 × 100% = 150,000
Accounts payable (100,000) (100,000) — ```````````` Business
Total fair value increment ````````````` 300,000 Combinations
Net asset book value $`800,000 × 100% = ````800,000
Fair value of assets acquired $1,100,000 97
Goodwill $```100,000

resulting balance amounts are identical to those shown in the second column of
Exhibit 3-5.
There is one aspect of Exhibit 3-7 that merits explanation. You’ll notice that
accumulated depreciation is calculated by adding the two companies’ amounts
together, and then subtracting Target’s accumulated depreciation at the date of
acquisition. We subtract Target’s accumulated depreciation because we want to
show the fair value of Target’s depreciable assets at the date of acquisition. This
amount is included in the capital asset account itself. If we carried Target’s accu-
mulated depreciation forward, we would be reducing the fair value. In effect, we
would be combining fair value in the asset account with written-off cost in the
accumulated depreciation. To emphasize the point, the CICA Handbook explic-
itly points out that “the accumulated depreciation of the acquired entity is not
carried forward” in the consolidated statements [ED 1580.38(d)].
Although we have indicated which adjustments on Exhibit 3-7 are for fair
value increments and which are eliminations, bear in mind that these purchase
adjustments and eliminations are not independent. Essentially, all of the adjust-
ments shown in Exhibit 3-7 are allocations of the $1,200,000 purchase price. In
future years, all of the components of this purchase adjustment must be made
simultaneously, as we will illustrate in the following chapters.

Worksheet method
Exhibit 3-8 shows the trial balance-based spreadsheet for Purchase’s consolidated
balance sheet. The separate-entity columns for the individual companies corre-
spond to the post-transaction balance sheets shown in the last two columns of
Exhibit 3-3.
The eliminations and adjustments that are necessary in order to prepare the
consolidated trial balance are composed of two elements. First, it is necessary to
eliminate the shareholders’ equity accounts of Target Ltd. by offsetting the bal-
ances of these accounts against the investment account:
 EXHIBIT 3–7 PURCHASE LTD. CONSOLIDATED BALANCE SHEET
Balance Sheet
December 31, 2001
Assets
Current assets:
Cash [1,000,000 + 50,000] $ 1,050,000
Accounts receivable [2,000,000 + 150,000] 2,150,000
Inventory [200,000 + 50,000] ``````250,000
```3,450,000
Property, plant, and equipment:
Land [1,000,000 + 300,000 + 100,000b] 1,400,000
Chapter Buildings and equipment [3,000,000 + 500,000 + 50,000b] 3,550,000
Three Accumulated depreciation [1,200,000 + 150,000 – 150,000b] (1,200,000)
```3,750,000
98
Other assets:
Investment in Target Ltd. [1,200,000 – 800,000a – 400,000b] —
Goodwill [+ 100,000b] ``````100,000
Total assets $``7,300,000

Liabilities and shareholders’ equity

Liabilities:
Current accounts payable [1,000,000 + 100,000] $ 1,100,000
Long-term notes payable [400,000 + 0] ``````400,000
```1,500,000
Shareholders’ equity:
Common shares [3,800,000 + 200,000 – 200,000a] 3,800,000
Retained earnings [2,000,000 + 600,000 – 600,000a] ```2,000,000
```5,800,000
Total liabilities and shareholders’ equity $``7,300,000

a Common shares (Target) 200,000

Retained earnings (Target) 600,000
Investment in Target Ltd. (Purchase) 800,000

The names in parentheses indicate the company trial balance to which that
particular elimination element refers. Again, we must emphasize that there is no
actual journal entry on either company’s books—this is purely a worksheet entry.
The second entry adjusts the asset accounts of the subsidiary from their car-
rying values on the subsidiary’s books to the fair values at the date of acquisition:
b Land (Target) 100,000
Buildings and equipment (Target) 50,000
Accumulated depreciation (Target) 150,000
Goodwill 100,000
Investment in Target Ltd. (Purchase) 400,000
 EXHIBIT 3–8 PURCHASE LTD. CONSOLIDATION WORKSHEET AT DATE OF ACQUISITION
December 31, 2001
Trial balances Purchase
Purchase Target Adjustments consolidated
Dr/(Cr) Dr/(Cr) Dr/(Cr) trial balance
Cash $ 1,000,000 $ 50,000 $ 1,050,000
Accounts receivable 2,000,000 150,000 2,150,000
Inventories 200,000 50,000 250,000
Land 1,000,000 300,000 100,000 b 1,400,000
Buildings and equipment 3,000,000 500,000 50,000 b 3,550,000
Accumulated depreciation (1,200,000) (150,000) 150,000 b (1,200,000)
}
Investment in Target Ltd. 1,200,000 — (800,000) a
(400,000) b } — Business

Combinations
Goodwill 100,000 b 100,000
Accounts payable (1,000,000) (100,000) (1,100,000) 99
Long-term notes payable (400,000) — (400,000)
Common shares (3,800,000) (200,000) 200,000 a (3,800,000)
Retained earnings ``(2,000,000) ``(600,000) ```600,000 a ``(2,000,000)
$``````````— $````````— $````````— $``````````—

The net result of these two adjustments is to eliminate the investment

account, eliminate the subsidiary’s share equity accounts at the date of acquisi-
tion, and establish the fair values of the assets and liabilities acquired by Purchase
through purchase of Target’s shares. These two adjustments will be made in every
subsequent period when the consolidated statements are prepared.

Negative Goodwill
In the example of a business combination used earlier in this chapter, control over
net assets with a fair value of $1,100,000 was acquired for $1,200,000. The dif-
ference between the purchase price and the fair value of the acquired net assets is
treated as goodwill.
It is not unusual, however, for the total fair value of the assets and liabilities
to be greater than the purchase price. This excess of fair values over the purchase
price is commonly known as negative goodwill, although the title is not partic-
ularly indicative of the accounting treatment of the amount. The total of the net
debits (to record the fair values) is greater than the credits (to record the consid-
eration paid), and therefore there are more debits than credits in the consolidated
statements—not a tolerable situation in a double-entry system. The task is to cor-
rect the balance by either increasing the credits or decreasing the debits.
Once upon a time, it was common practice to increase the credits by estab-
lishing an account to credit for the amount of negative goodwill. It was not nor-
mally called “negative goodwill,” of course. Usually a more opaque title was
chosen, such as “excess of fair value over cost of assets acquired.” This is now a
prohibited practice in Canada, and in most countries. Instead of creating a credit
for negative goodwill, the balance of debits and credits must be achieved by
reducing the total amount allocated to the net assets.
 Negative goodwill is, in essence, an indication that the acquirer achieved a
bargain purchase. A bargain purchase is possible for a variety of reasons. If the
acquisition is by a purchase of shares, then the market price of the acquiree’s
shares may be well below the net asset value per share. Or if the acquiree is a pri-
vate company, a bargain purchase may be possible if the present owners are anx-
ious to sell because of the death of the founder-manager, divorce, changed family
financial position, or simply an inability to manage effectively.
Regardless of the reason, negative goodwill should be viewed as a discount on
the purchase and not as a special credit to be created and amortized. When any
company buys an asset at a bargain price, the asset is recorded at its cost to the
purchaser, and not at any list price or other fair value. For example, suppose that
a company buys a large computer from a financially troubled distributor for only
$80,000. The price of the computer from any other source would be $120,000.
Chapter On the buyer’s books, the computer obviously would be recorded at $80,000, not
Three
at $120,000 with an offsetting credit for $40,000.
The same general principle applies to bargain purchases in business combi-
100 nations. The purchase price is allocated to the acquired assets and liabilities on
the basis of fair values, but not necessarily at fair values if the total fair value
exceeds the purchase price. A problem does arise, however, in deciding to which
assets and liabilities the bargain prices or negative goodwill should be assigned.
A business combination involves the assets and liabilities of a going concern.
The net assets acquired usually comprise a mixture of financial and non-
financial, current and long-term assets and liabilities. Because the various assets
and liabilities have varying impacts on reported earnings, the allocation of nega-
tive goodwill will affect the amount of future revenues and expenses.
For example, suppose that Purchase acquired all of the shares of Target, as
above, but at a cost of only $1,050,000. Since the fair value of Target’s net assets
is $1,100,000, negative goodwill of $50,000 exists. Target’s assets and liabilities
will be reported on Purchase’s consolidated balance sheet at a total amount of
$1,050,000, $50,000 less than their fair values. At least one of the Target assets
must be reported at an amount that is less than its fair value.
If the negative goodwill were assigned to inventory, Target’s inventory would
be consolidated at zero value, since the fair value of Target’s inventory was
assumed to be $50,000 (Exhibit 3-4). Reduction in the cost assigned to inven-
tory will flow through to the income statement in the following year as a reduc-
tion in cost of goods sold and an increase in net income. If, on the other hand,
the negative goodwill were assigned to buildings and equipment, then the effect
of the bargain purchase would be recognized over several years in the form of
reduced depreciation on the lower cost allocated to buildings and equipment.
Allocation of the negative goodwill to land would result in no impact on earn-
ings until the land was sold; allocation to monetary receivables would result in a
gain when the receivables were collected.
The choice of assets to report at less than fair values is essentially arbitrary.
The AcSB [ED 1580.32] recommends that negative goodwill should be allocated
in the following order:
1. pro rata to any intangible assets that do not have an observable market value,
and then
2. pro rata to depreciable non-financial assets (both tangible and intangible).

If the purchase price allocations to the non-financial assets have all been
reduced to zero and there still is negative goodwill remaining, the remaining
amount is recognized as an extraordinary gain, even though the normal condi-
tions for recognizing an extraordinary gain have not been met.
Disclosure
Business combinations are significant events. They often change the nature of
operations of a company and thus change the components of the earnings stream.
All users’ financial reporting objectives are affected by substantial business com-
binations. At a minimum, the asset and liability structure of the reporting enter-
prise is changed. Disclosure of business combinations therefore is quite
important.
The AcSB recommends a long list of disclosures for business combinations
completed during the period [ED 1580.65-1580.68]. We will not reproduce the
list here, but the acquirer should disclose essential aspects such as:
• a description of the acquired subsidiary, its business, the date of purchase, and
the nature of the purchase transaction,
Business
• the cost of the acquisition and the nature and value of the consideration
Combinations
given,
• a summary of the major classes of asset and liability acquired, 101

• the amount of the purchase price that is attributed to goodwill, and

• the nature of any contingent consideration.

For acquisitions that are individually immaterial, similar information should

be disclosed in the aggregate [ED 1580.66].
Also, the acquirer should disclose significant intangible assets that have been
acquired as part of the business combination. The nature of the assets and the
amortization basis should be described.
Exhibit 3-9 shows the 1999 disclosure note of Geac Computer Corporation
Limited. This disclosure has several interesting aspects:
• Geac acquired seven businesses during fiscal 1999.
• Three of the business combinations were purchases of assets; the other four
were purchases of shares. One of the asset purchases (Cruickshank
Technology) included the shares of a subsidiary.
• In all seven acquisitions, Geac paid cash.
• The purchase price for News Holdings Corp. was $25,808,000. Of the pur-
chase price, $45,842,000 was allocated to goodwill, 178% of the purchase
price. The reason that goodwill is higher than the purchase price is that the
acquired company had a negative net asset value (i.e., more liabilities than
assets).
• In aggregate, the other acquired businesses also had negative net assets—
goodwill amounted to 186% of the total purchase prices.

Exhibit 3-10 (page 103) illustrates disclosure of another purchase. In this

case, the acquisition was of significant influence, and therefore is not a business
combination. Corel will report this investment by the equity method, as the note
states. An unusual aspect of Corel’s purchase of 25% of Rebel.com is that the
consideration was neither cash nor shares—the purchase was paid for by exchang-
ing the assets shown in the note, described as follows in Corel’s MD&A
(Management’s Discussion and Analysis):
 On February 17, 1999, the Company transferred all of the assets of Corel Computer
supporting the NetWinder family of Linux-based thin client/thin server computers
and $1.6 million cash in exchange for a 25% equity stake in Rebel.com.

Recording Fair Values: Push-Down Accounting

We have emphasized that the fair values of the net assets of the acquiree are never
recorded in the books of the acquirer; the full purchase price is simply recorded
in an investment account on the acquirer’s books. We have also stated that when
a business combination is accomplished by a purchase of shares (rather than by a
direct purchase of assets), the acquiree continues to exist as a separate legal and
reporting entity. The carrying values of the acquiree’s net assets are not affected
Chapter by the acquisition or by the fair values attributed to the assets by the acquirer.
Three

102
EXHIBIT 3–9 DISCLOSURE OF ACQUISITIONS
Geac Computer Corporation
13. ACQUISITIONS
Year ended April 30, 1999
During the year ended April 30, 1999, the Company acquired for cash the businesses shown
in the table below. Cruickshank Technology Pty Limited, Stowe Computing Australia, Stowe
Computing Finance Pty Limited, Stowe Computing (NZ) Limited, and Phoenix Systems Limited
were asset purchases. The Company acquired the remaining 75% interest in its former joint
venture Soluzioni Gestionali. In each of the remaining acquisitions, the Company acquired all
of the issued and outstanding shares. Acquisitions are accounted for by the purchase method
with the results of operations of each business included in the financial statements from the
respective dates of acquisition. Geac accrues or reserves for known or anticipated customer,
supplier, or other problems at the time of acquisition just as it would in ongoing businesses.
The total purchase price of News Holdings Corp. and its subsidiary Interealty Corp. was
$25,808. The acquired business included, at fair value, $13,685 of current assets, $11,654 of
fixed assets, and $45,373 of current liabilities. The difference between the total purchase
price and the net fair value of all identifiable assets and liabilities acquired was $45,842 and
is accounted for as goodwill.
The total purchase price of the remaining acquired business was $15,088. These busi-
nesses included, at fair value, $979 of cash, $10,833 of other current assets, $1,191 of fixed
assets, and $26,032 of current liabilities. The difference between the total purchase price and
the net fair value of all identifiable assets and liabilities acquired was $28,117 and is
accounted for as goodwill.

Acquisition Effective date

Remanco International, Inc. and its subsidiary Remanco Systems, Ltd. May 31, 1998
Assets of Cruickshank Technology Pty Limited and all of the issued
and outstanding shares of its subsidiary Mainpac Limited June 1, 1998
News Holdings Corp. and its subsidiary Interealty Corp. September 7, 1998
Soluzioni Gestionali SrL October 15, 1998
TWG Technologies Inc. December 1, 1998
Assets of Stowe Computing Australia Pty Ltd., Stowe Computing
Finance Pty Limited and Stowe Computing (NZ) Limited December 3, 1998
Assets of Phoenix Systems Limited April 30, 1999
 EXHIBIT 3–10 PURCHASE OF SIGNIFICANT INFLUENCE
Corel Corporation
3. Investments
(a) Rebel.com
On February 17, 1999, the Company purchased a 25% interest in Rebel.com for $3,351,000.
The Company’s share of the net book value of the underlying assets was $1,299,000. The
remaining balance of the purchase price of $2,052,000 has been allocated to goodwill and is
being amortized on a straight-line basis over three years. The fair value of the assets used to
purchase the Company’s share of Rebel.com was as follows (in thousands of US$):

Cash $ 1,561
Capital assets 1,341
Inventory 381 Business

Accounts receivable 68 Combinations

Total purchase price $ 3,351 103

The Company is accounting for this investment using the equity method. In 1999, $342,000 of
goodwill was amortized and the Company’s share of Rebel.com’s net loss of $136,000 was
deducted from the value of the investment.

An exception to the general rule that the acquiree’s carrying values are unaf-
fected by the purchase may arise when substantially all of the acquiree’s shares are
purchased by the acquirer. In that case, the acquirer may direct the acquiree to
revalue its assets in accordance with the fair values attributed thereto by the
acquirer. This practice is known as push-down accounting, because the fair val-
ues are “pushed down” to the acquiree’s books. The net effect is the same as if the
acquirer had formed a new subsidiary, which then purchased all of the assets and
liabilities of the acquiree.
There are two advantages to push-down accounting. The first is that the
financial position and results of operations of the acquiree will be reported on the
same economic basis in both the consolidated statements and its own separate-
entity statements. Without push-down accounting, for example, it would be pos-
sible for the subsidiary to report a profit on its own and yet contribute an
operating loss to the parent’s consolidated results, if the consolidation adjust-
ments are sufficient to tip the balance between profit and loss.
The second advantage is that the process of consolidation will be greatly sim-
plified for the parent. Since the carrying values will be the same as the acquisition
fair values, there will be no need for many of the consolidation adjustments that
otherwise will be required every time consolidated statements are prepared.
Although push-down accounting is used in Canada, the practice is more
prevalent in the United States, where the Securities and Exchange Commission
requires its registrants to use the practice when an acquired subsidiary is “sub-
stantially” wholly owned and there is no publicly held debt or senior shares.
In 1992, the CICA Accounting Standards Board issued CICA Handbook sec-
tion 1625, “Comprehensive Revaluation of Assets and Liabilities.” Push-down
accounting may be used when:

All or virtually all of the equity interests in the enterprise have been acquired, in one
or more transactions between non-related parties, by an acquirer who controls the
enterprise after the transaction or transactions. [CICA 1625.04(a)]
 A guideline of 90% ownership is provided for the phrase “virtually all of the
equity interests” [CICA 1625.10]. Note that the recommendation provides for
acquisitions that are accomplished by a series of smaller share purchases rather
than by one large transaction—substantially complete ownership need not be
achieved all at once.
Despite the permissibility of applying push-down accounting, acquirers may
choose not to apply push-down accounting to subsidiaries that have outstanding
public debt. The reason is that the basis for assessing contract compliance is dis-
turbed by an asset revaluation. Reported results (e.g., earnings per share) will be
discontinuous, and debt covenants may be violated or rendered less suitable if the
reporting basis is changed. Indeed, debt agreements with banks may be based on
accounting principles in effect on the date of the agreement, and thereby effec-
tively constrain the application of push-down accounting.
Chapter A special case of push-down accounting arises in a reverse takeover. In a
Three
reverse takeover, it is the legal acquirer that is really the in-substance acquiree—
the fair values reported on the consolidated statements will be those of the com-
104 pany issuing the statements (the legal parent but in-substance subsidiary). In that
case, it makes little sense for the in-substance acquiree to be carrying its assets and
liabilities at book values that will never be reported in its own financial state-
ments. It is more logical simply to put the fair values on the books of the in-
substance acquiree.

Summary of Key Points

1. A business combination is the acquisition of net assets or control over net

assets that constitute a functioning business. Control over net assets is usually
obtained by buying a majority of the shares in the operating company that
owns the assets. When control is acquired, the acquired net assets remain the
property of the controlled subsidiary. Therefore, consolidated financial state-
ments are necessary.
2. Accounting for a business combination requires three steps: (1) determine the
cost of the acquisition, or purchase price, (2) determine the fair values of the
acquired assets and liabilities, and (3) allocate the purchase price to the iden-
tifiable assets and liabilities, with any excess attributed to goodwill.
The basis for the allocation of purchase price is the fair values of the
acquired assets and liabilities. If the purchase price is less than the aggregate
fair value of the net assets, negative goodwill arises. The value assigned to
non-financial assets, starting with intangible assets with no observable market
value, must be reduced until the total allocated amount equals the purchase
price.
If the purchase price is less than the fair value of the non-financial assets,
the excess of fair value over the purchase price is recognized as an extraordi-
nary item.
A purchase of net assets may be accomplished (1) by paying cash or other
assets or (2) by issuing shares. A combination of cash and shares may be used.
When shares are issued, the purchase price is based on the market value
of the shares, if determinable. If the market value of issued shares is not deter-
minable, the fair value of the net assets acquired may be used as the measure
of the purchase price. Fair values are determined on various bases, depending
on the type of asset or liability. Generally, fair values of assets are based on net
 realizable values, replacement costs, and appraised values. Liabilities are meas-
ured at their discounted present value, using the market rate of interest at the
time of the combination.
If the net assets are purchased directly, the fair values of the acquired assets
and liabilities are recorded on the books of the acquirer. There is no parent-
subsidiary relationship because the acquirer did not buy another corpora-
tion—it bought the net assets instead.
3. Acquisition of majority control over another company enables the investor to
obtain control over the assets without having to pay the full fair value of the
assets. Shares can be purchased for cash or other assets. Alternatively, the pur-
chaser can issue its own shares in exchange for the shares of the acquiree. If
there is an exchange of shares, the acquirer does not have to give up any cash.
The previous holders of the acquiree’s shares now hold shares in the acquirer
Business
instead.
Combinations
4. Theoretically, there are three approaches to reporting consolidated financial
statements following purchase of control over another corporation: pooling, 105
purchase, and new entity.
Under the pooling method, the book values of the parent and the sub-
sidiary are simply added together and reported as the consolidated amounts.
Under purchase accounting, the date-of-acquisition fair values of the sub-
sidiary are added to the parent’s book values. The purchase method of con-
solidation gives the same results as if the net assets had been purchased
directly.
With the new-entity method, the fair values of the parent and the sub-
sidiary are added together to form a new basis of accountability for the ongo-
ing economic entity.
5. Pooling has been in widespread use only in the U.S.A. Other countries,
including Canada, have sharply limited pooling to those rare instances in
which an acquirer cannot be identified. Effective in 2001, the pooling
method is not permitted for arm’s-length business combinations by the CICA
Handbook, by FASB standards in the U.S.A., or by International Accounting
Standards. However, the pooling method is applied to non-arm’s-length cor-
porate restructurings, including the combination of companies under com-
mon control.
6. Normally, fair values are not recorded on the books of the acquiree; adjust-
ments are made solely on working papers to prepare consolidated financial
statements. However, fair values may be recorded on the books of the
acquired company if the investor corporation has acquired substantially all of
the shares of the subsidiary. This practice is known as push-down accounting.

Weblinks
Ontario Securities Commission
www.osc.gov.on.ca/
The Ontario Securities Commission administers and enforces securities legisla-
tion in the Province of Ontario. Their mandate is to protect investors from unfair
improper and fraudulent practices, foster fair and efficient capital markets, and
maintain public and investor confidence in the integrity of those markets. Learn
about the rules and regulations, market participants, and investor resources from
this comprehensive Web site.
 Allied Hotel Properties
www.alliedhotels.com/
Allied Hotel Properties is a Canadian hotel company focused on the ownership
of first class business hotels in major Canadian urban centres. Properties include
the Crowne Plaza Hotel Georgia and Delta Pacific Resort & Conference Centre
in Vancouver, Crowne Plaza Chateau Lacombe in Edmonton, and Crowne Plaza
Toronto Don Valley Hotel in Toronto. Read news releases and stock quotes at
their Web site.
Corel
www.corel.com
From its early years as a pioneer in the graphics software field to its current inno-
vations in business and Internet software for a variety of platforms, Corel has con-
Chapter sistently developed products that respond to evolving consumer needs. Current
Three
products include CorelDraw, WordPerfect, and Corel Painter. Find out more
about these programs or order them online at their Web site.
106
Self-Study Problem 3-1
Ace Corporation acquired Blue Corporation on August 31, 2004. Both corpora-
tions have fiscal years ending on August 31. Exhibit 3-11 shows the balance sheet
for each corporation as of August 31, 2004, immediately prior to the combina-
tion, and net income amounts for each corporation for the fiscal year ended
August 31, 2004.
The fair values of the assets and liabilities of the two companies at the date of
acquisition are shown in Exhibit 3-12. The deferred development costs represent
the unamortized amount of the companies’ leading-edge products. There is no
observable market value for this identifiable intangible asset, but Ace expects to
fully recover the costs in future years.
Before the combination, Ace had 1,200,000 common shares issued and out-
standing. Blue had 750,000 common shares issued and outstanding.

EXHIBIT 3–11 PRE-COMBINATION BALANCE SHEETS, AUGUST 31, 2004

Ace Blue
Cash and cash equivalents $ 2,350,000 $ 1,200,000
Accounts receivable 2,000,000 1,800,000
Land 5,000,000 —
Machinery and equipment, net 13,500,000 8,400,000
Deferred development costs ``````600,000 ````3,100,000
$23,450,000 $14,500,000
Accounts payable $ 650,000 $ 1,100,000
Notes payable, long-term 2,000,000 1,000,000
Common shares 15,000,000 6,950,000
Retained earnings ````5,800,000 ````5,450,000
$23,450,000 $14,500,000
Net income, year ended August 31, 2004 ````2,450,000 ````1,300,000
 EXHIBIT 3–12 FAIR VALUES, AUGUST 31, 2004
Ace Blue
Cash and cash equivalents $ 2,350,000 $ 1,200,000
Accounts receivable 2,000,000 1,800,000
Land 8,500,000 —
Machinery and equipment, net 11,000,000 11,000,000
Deferred development costs 750,000 4,000,000
Accounts payable (650,000) (1,100,000)
Notes payable, long-term ```(2,000,000) `````(900,000)
Net asset fair value $21,950,000 $16,000,000

Business
Required: Combinations
Prepare the Ace Corporation post-combination balance sheet under each of the
following independent situations: 107

1. Ace Corporation purchased the assets and assumed the liabilities of Blue
Corporation by paying $2,000,000 cash and issuing long-term instalment
notes payable of $18,000,000.
2. Ace issued 400,000 common shares for all of the outstanding common shares
of Blue. The market value of Ace’s shares was $50 per share.
3. Ace purchased 100% of Blue’s outstanding common shares from Blue’s pre-
vious shareholders. As consideration, Ace issued 270,000 common shares and
paid $1,000,000 in cash. The market value of Ace’s shares was $50 per share.

Appendix
Income Tax Allocation
Introduction
In your intermediate accounting course, you undoubtedly studied the topic of
income tax allocation. The effects of income tax allocation show up as “future
income taxes” on almost all balance sheets, as well as being a component of
income tax expense. Future income taxes arise from two causes:
1. temporary differences between accounting income and taxable income, and
2. unrealized tax loss carryforwards.

In the main body of Chapter 3, we avoided any discussion of future income

taxes as they relate to business combinations. However, they do play a part in the
allocation of the purchase price and the calculation of goodwill. We have left this
topic to an Appendix because we did not want to obscure the principal issues of
accounting for business combinations. Income taxes are not irrelevant, but they
are not central to an understanding of business combinations and the reporting
of strategic investments.
 Temporary differences in business combinations
In general, temporary differences arise because the carrying values of assets (and
liabilities) differ from their tax bases. The most common type of temporary dif-
ference relates to depreciable capital assets—book depreciation methods
(accounting method) are usually different from CCA (tax method), and therefore
an asset’s carrying value is different from its tax basis.
A similar situation arises in business combinations. The cost allocated to an
asset in a business combination is based on the asset’s fair value. The fair value
then becomes its carrying value. However, Canada Customs and Revenue Agency
doesn’t care about an asset’s fair value—only its tax basis matters. Therefore, a
temporary difference arises and must be dealt with.
For the purpose of consolidated statements, an asset’s temporary difference is
measured as the difference between its tax basis and the carrying value on the par-
Chapter
ent’s consolidated financial statements—which is based on the asset’s fair value at
Three the date of acquisition. The relevant carrying value is not its carrying value on the
books of the subsidiary.
108
Exhibit 3-13 attempts to clarify the situation. Suppose that a newly acquired
subsidiary, S, has an asset with a tax basis of $70 and a carrying value on S’s books
of $100. The temporary difference is $30. If S’s tax rate is 40%, the future
income tax liability pertaining to that asset is $30 × 40% = $12 on S’s separate-
entity balance sheet.
However, the fair value of that asset is $150. P, the parent company, will show
the asset on P’s consolidated balance sheet at $150. For P’s consolidated state-
ments, the temporary difference is $150 – $70 = $80. At a 40% tax rate, the
future income tax liability pertaining to that asset is $80 × 40% = $32 on P’s con-
solidated balance sheet.
The amount shown as the future income tax liability on P’s consolidated bal-
ance sheet does not affect the tax status of S. S and P are each taxed as a separate
corporate entity.
Now, let’s apply income tax allocation to the example in the main body of this
chapter.
• Purchase acquired 100% of the shares of Target for $1,200,000.
• The carrying value of Target’s net assets on Target’s books was $800,000.

EXHIBIT 3–13 TEMPORARY DIFFERENCES IN BUSINESS COMBINATIONS

Tax basis for S $70  

 
 $30 TD for S 
 separate-entity 
 
Carrying value on S’s   $80 TD for P
separate-entity balance sheet $100  
 consolidated



Carrying value on P’s 
consolidated balance sheet $150 

TD = temporary difference.
The future income tax liability is the TD × the tax rate.
 • Fair value increments totalled $300,000: $100,000 for land plus $200,000
for buildings and equipment.
• Goodwill was $100,000.

Let’s make some additional assumptions:

• The tax basis for the land is equal to its carrying value on Target’s books of
$300,000.
• The tax basis of Target’s buildings and equipment is $250,000.
• The tax basis for all other Target Ltd. assets and liabilities is equal to their car-
rying values.
• The tax rate for both Target and Purchase is 40%.
Business

The relevant amounts can be summarized as follows. Combinations

Buildings 109
Land & Equipment Total
Tax basis $300,000 $250,000 $550,000
Target Ltd.’s carrying value 300,000 350,000 650,000
Fair value to Purchase Ltd. 400,000 550,000 950,000

For Target Ltd., the total temporary difference is $650,000 – $550,000 =

$100,000. The future income tax liability is $100,000 × 40% = $40,000. For
simplicity’s sake, we did not include this amount among the net assets shown in
the main body of the chapter.
For Purchase Ltd.’s consolidated statements, the temporary difference is
$400,000, and the future income tax liability (at 40%) is $160,000. Exhibit
3-14 shows the allocation of the purchase price with the future income tax lia-
bility included. We have fudged the original amounts a bit by subdividing
accounts payable and shifting $40,000 to a future income tax liability account,

EXHIBIT 3–14 ALLOCATION OF PURCHASE PRICE, INCLUDING FUTURE INCOME TAXES

100% purchase of Target Ltd., December 31, 2001
Purchase price $1,200,000
Fair Fair value % FVI
Book value value increment share acquired
Cash $ 50,000 $ 50,000 —
Accounts receivable 150,000 150,000 —
Inventory 50,000 50,000 —
Land 300,000 400,000 $ 100,000 × 100% = $ 100,000
Buildings and equipment 500,000 550,000 50,000 × 100% = 50,000
Accumulated depreciation (150,000) — 150,000 × 100% = 150,000
Accounts payable (60,000) (60,000) —
Future income tax liability (40,000) (160,000) (120,000) × 100% = ``(120,000)
Total fair value increment ````````````` 180,000
Net asset book value $`800,000 ```````````` × 100% = ````800,000
Fair value of assets acquired $980,000 $```980,000
Goodwill $```220,000
 to be consistent with our calculation of Target’s temporary differences. This slight
adjustment to the original numbers maintains the total amount of Target’s net
assets at $800,000. Thus we can clearly see what impact future income taxes have
on the allocation of the purchase price.
Notice what happens to goodwill. Because we now are recognizing a liability
that we did not recognize in Exhibit 3-6, the amount of the purchase price that
is allocated to the net assets goes down. This forces the difference between the
purchase price and the net book value to go up, thereby increasing the residual.
The residual is goodwill. Therefore, the net result of recognizing the future
income taxes is to increase liabilities with an offsetting increase in goodwill.
The current recognition of future income taxes based on consolidation fair val-
ues has been subject to some criticism. Prior to the effective date of Section 3465
(in 2000), fair value increments were viewed as permanent differences because the
Chapter fair value increments never flow through to the income tax return. Fair value incre-
Three
ments are purely an accounting construct and are irrelevant for tax purposes.
Now, however, temporary differences are recognized in this situation because
110 the current approach to income tax accounting requires a future tax liability to be
recognized on the assumption that assets are sold at their carrying values, thereby
attracting taxation.1 Since the carrying values for a purchased subsidiary are the
fair values at date of acquisition, strict application of the concept results in the
recognition of future income tax liabilities for what are sometimes called “phan-
tom” values.
What happens to these amounts? We shall see in the following chapters that
the fair value increments must be amortized (except for land). As the fair values
are amortized, the temporary difference goes down and the future income tax lia-
bility is comparably reduced. As well, goodwill (at its heightened amount) is
either amortized or subjected to the impairment test. Therefore, the recognition
of future income tax liabilities based on fair values triggers three types of inter-
period allocation in following years. Such complexity is the reason that we have
chosen to put income tax allocation factors in Appendices rather than in the main
body of each chapter.

Unrecognized tax loss carryforwards

One valuable asset that some companies have is tax loss carryforwards.
Sometimes, this is a target company’s most attractive asset. When substantial
amounts of unused tax loss carryforwards exist, a purchaser may be willing to pay
quite a lot for those benefits even if the target company appears to be a real loser.
To obtain the benefit of tax loss carryforwards, the business combination must be
accomplished through an exchange of shares, not by paying cash (or other assets).
The target company may or may not have already recognized those benefits
on their balance sheet. Recognition depends on the “more likely than not” crite-
rion prior to acquisition. If the company has serious financial difficulties, the
probability criterion won’t have been met and therefore their tax losses would not
be recorded as a future income tax asset. However, the acquisition may change
the probabilities, so that the “more likely than not” criterion may have now been
met. Therefore these losses now have value to the parent company. The losses will
be recognized at their fair value in the purchase price allocation and be identified
as a future income tax asset in the purchaser’s consolidated balance sheet.
Using the following data we will consider what will happen in a business
combination under two scenarios. XYZ Corporation purchased 100% of the

1. CICA 3465.02.
shares of ABC Corporation for $2,000,000 and the fair value of the net assets
(excluding tax losses) totalled $1,400,000. In addition, unused tax loss carryfor-
wards that the target company had not recorded on the books have a fair value of
$200,000.
If it is more than 50% likely that the benefit will occur, then the purchase
price will be allocated as follows:
Purchase price $2,000,000
Fair value of net assets acquired
(excluding tax loss benefits) $1,400,000
Future income tax asset ````200,000 ``1,600,000
Goodwill $```400,000

If the “more likely than not” criterion has not been met, the purchase price
Business
will be recorded as:
Combinations
Purchase price $2,000,000
Fair value of net assets acquired 111
(excluding tax loss benefits) $1,400,000
Future income tax asset `````````````0 ``1,400,000
Goodwill $```600,000

Note the difference in the goodwill amount depending on whether the “more
likely than not” criterion has been met. This difference will have an impact on
future financial statements through increased amortization expense when good-
will is recognized at a higher amount. If the future income tax asset is recognized
this will be considered a temporary difference.

Equity-basis reporting
The preceding brief discussion focused on business combinations. However,
exactly the same process is followed for all investments that are reported on the
equity basis, whether they are unconsolidated subsidiaries or significantly influ-
enced affiliates. Temporary differences and future tax loss carryforward benefits
must enter the allocation of the purchase price exactly as illustrated above.

Review Questions

3-1 Define the following terms:

a. Business combination
b. Net assets
c. Goodwill
d. Negative goodwill
e. Hostile takeover
f. Statutory amalgamation
g. Reverse takeover
h. Purchase price discrepancy
i. Exchange of shares
j. Corporate restructuring
k. Push-down accounting
 3-2 Describe the two basic types of acquisitions that can result in a business
combination.
3-3 What are the three steps in accounting for a business combination?
3-4 What are the forms of consideration that can be used in a business combi-
nation?
3-5 When one corporation buys the assets or assets and liabilities of another
company, at what values are the acquired assets recorded on the buyer’s
books?
3-6 Does a direct purchase of assets constitute an intercorporate investment
by the buying company?
3-7 P Ltd. has just purchased all of the assets of S Corp.’s automobile parts
Chapter
division. S Corp. had shut down the division the year before. Has a busi-
Three ness combination occurred? Explain.
112 3-8 In general, how would fair values be determined for productive assets?
3-9 In general, how would fair values be determined for liabilities?
3-10 When an acquirer buys the net assets of another company by issuing
shares, what is the relationship between the two companies after the trans-
action has taken place?
3-11 On what basis is the cost of a purchase of assets allocated?
3-12 What are the advantages for the acquirer of obtaining control over assets
by a purchase of shares rather than by a direct purchase of assets?
3-13 What are the disadvantages for the acquirer of obtaining control by a pur-
chase of shares?
3-14 For the acquirer, what is the difference in income tax treatment of good-
will acquired in a direct purchase of assets as compared to goodwill
acquired in a purchase of shares?
3-15 How can an acquirer obtain control if the management of the acquiree is
hostile to the business combination?
3-16 If an acquirer issues a tender offer, is it necessary for the offering company
to buy all of the shares tendered?
3-17 From an income tax standpoint, what may be the disadvantages for an
acquirer in obtaining control through a purchase of shares rather than by
a direct purchase of net assets?
3-18 Company P issues its shares in exchange for the shares of Company S.
After the exchange, who owns the newly issued shares of P?
3-19 In an exchange of shares, how can the acquirer be identified?
3-20 What is the most common reason for a combination of a public company
and a private company accomplished by means of a reverse take-over?
3-21 In consolidated statements following a reverse take-over, which company’s
net assets are reported at fair values: the legal acquirer or the legal sub-
sidiary?
3-22 Why is a reverse take-over often immediately followed by a name change
of the legal parent corporation?
3-23 In what form(s) of business combination do the combining companies
cease to exist as separate legal entities?
3-24 When a business combination is executed via a purchase of shares, at what
values are the assets and liabilities of the acquiree recorded on the books
of the acquirer?
3-25 Briefly explain the difference between these three approaches to preparing
consolidated financial statements:
a. Pooling-of-interests method
b. New-entity method
c. Purchase method
3-26 What is the purchase price discrepancy?
Business
3-27 What is the logic underlying the use of pooling-of-interests reporting for a
Combinations
business combination?
3-28 How prevalent is pooling-of-interests reporting in Canada? 113
3-29 What is the essential characteristic that must be present in a business
combination in order for it to be reported as a pooling of interests?
3-30 How does the treatment of pre-combination financial data differ under
pooling-of-interests reporting as compared to purchase reporting for a
business combination?
3-31 What is a corporate restructuring? How are restructurings accounted for?
3-32 Why has the new-entity method not found acceptance in practice?
3-33 What is the recommended treatment of negative goodwill, according to
the CICA Handbook?
3-34 Company P has 800,000 common shares outstanding. The shares are
traded on the Montreal Exchange. The founders and managers of
Company P hold 200,000 shares, and another 250,000 are held by insti-
tutional investors as long-term investments. P’s board of directors has
approved issuance of an additional 300,000 shares to acquire the net
assets of Company S. What difficulties may arise in attempting to set a
value on the newly issued shares in order to determine the cost of the
acquisition?
3-35 Under what circumstances would a corporation be able to obtain control
over the net assets of another corporation for less than the fair value of
those net assets?
3-36 Define push-down accounting.
3-37 Under what circumstances is push-down accounting most likely to be
used?
 Cases
Case 3-1
XYZ Ltd.
During 2001, XYZ Ltd. purchased for cash all of the 100,000 Class B shares of
Sub Limited. Each share carries one vote. The previous owner, Mr. Bill, retained
all 20,000 outstanding Class A shares of Sub Limited, each carrying four votes.
In order to avoid sudden changes, Mr. Bill stipulated in the sale agreement that
he was to retain the right to refuse the appointment of management for Sub
Limited and to approve any significant transactions of Sub Limited.

Required:
Chapter Should XYZ Ltd. consolidate the operations of Sub Limited in its 2001 financial
Three statements, which are to be issued in accordance with generally accepted account-
ing principles? Provide support for your recommendation.
114 [CICA]

Case 3-2
Boatsman Boats Limited
Boatsman Boats Limited (BBL) is a dealer in pleasure boats located in Kingston,
Ontario. The company is incorporated under the Ontario Business Corporations
Act and is wholly owned by its founder and president, Jim Boatsman. In 2000,
BBL had revenues of $2,500,000 with total assets of about $1,000,000 at year-
end.
Late in 2001, Jim Boatsman reached an agreement with Clyde Stickney for
the combination of BBL and Stickney Skate Corporation (SSC). SSC is a manu-
facturer of ice skates and is located in Ottawa, Ontario. SSC’s 2000 revenue
totalled $2,000,000 and year-end assets totalled $1,500,000. Clyde Stickney is
president and general manager of SSC, and he owns 65% of the SSC shares. The
other 35% is owned by Clyde’s former partner, who left the business several years
previously because of a policy disagreement with Clyde.
Clyde and Jim decided to combine the two businesses because their seasonal
business cycles were complementary. Common ownership would permit working
capital to be shifted from one company to the other, and the larger asset base and
more stable financial performance of the combined company would probably
increase the total debt capacity.
Under the terms of the agreement, BBL would issue common shares to Clyde
Stickney in exchange for Clyde’s shares in SSC. As a result of the exchange, Jim’s
share of BBL would drop to 60% of the outstanding BBL shares, and Clyde
would hold the remaining 40%. Clyde and Jim signed a shareholders’ agreement
that gave each of them equal representation on the BBL board of directors.
As the end of 2001 approached, Jim, Clyde, and CA (the BBL auditor) were
discussing the appropriate treatment of the business combination on BBL’s 2001
financial statements. Clyde was of the opinion that CA should simply add together
the assets and liabilities of the two companies at their book values (after eliminat-
ing intercompany balances and transactions, of course). Jim, on the other hand,
thought that the combination had resulted in a new, stronger entity, and that the
financial statements should reflect that fact by revaluing the net assets of both BBL
and SSC to reflect fair values at the date of the combination. CA, however, insisted
that only SSC’s net assets should be revalued, and then only to the extent of the
65% of the assets that were represented by BBL’s shareholdings in SSC.
While Jim and Clyde disagreed with each other on the appropriate valuation
of the assets, both disagreed with CA’s proposal. Jim and Clyde clearly controlled
SSC through BBL, they argued; that was the whole point of the combination. In
their opinion it would be inappropriate to value the same assets on two different
bases, 65% current value and 35% book value. If only SSC’s assets were to be
revalued, then they reasoned that the assets at least should be valued consistently,
at 100% of fair value.
In an effort to resolve the impasse that was developing, Jim and Clyde hired
an independent consultant to advise them. The consultant was asked (1) to advise
the shareholders on the pros and cons of each alternative in BBL’s specific case,
and (2) to make a recommendation on a preferred approach. The consultant was
supplied with the condensed balance sheets of BBL and SSC as shown in Exhibit Business
1, and with CA’s estimate of fair values (Exhibit 2). Combinations

Required: 115
Prepare the consultant’s report. Assume that the business combination took place
on December 31, 2001.

EXHIBIT 1
Condensed Balance Sheets
December 31, 2001
Boatsman Stickney
Boats Ltd. Skate Corp.
Current assets $ 600,000 $ 350,000
Land — 250,000
Buildings and equipment — 2,500,000
Accumulated depreciation — (1,500,000)
Furniture and fixtures 800,000 300,000
Accumulated depreciation (330,000) (100,000)
Investment in Stickney Skate Corp. ``1,300,000 ````````````—
Total assets $2,370,000 $ 1,800,000
Current liabilities $ 370,000 $ 400,000
Long-term liabilities 300,000 900,000
Common shares 1,500,000 200,000
Retained earnings ````200,000 `````300,000
Total equities $2,370,000 $`1,800,000
 EXHIBIT 2
Net Asset Fair Values
December 31, 2001
Boatsman Stickney
Boats Ltd. Skate Corp.
Current assets $ 600,000 $ 350,000
Land — 700,000
Buildings and equipment:
estimated replacement cost new — 5,000,000
less depreciation — (3,000,000)
Furniture and fixtures:
estimated replacement cost new 1,300,000 500,000
Chapter less depreciation (520,000) (240,000)
Three Current liabilities (370,000) (400,000)
Long-term liabilities* ````(270,000) `````(930,000)
116
Net asset fair value $```740,000 $`1,980,000

* Discounted at current long-term interest rates.

[ICAO]

Case 3-3
Ames Brothers Ltd.
Ames Brothers, Ltd. (ABL) is a relatively small producer of petrochemicals
located in Sarnia. The common shares of the firm are publicly traded on the
Brampton stock exchange, while the non-voting preferred shares are traded on
the over-the-counter market. Because of the strategic competitive position of the
firm, there was considerable recent interest in the shares of the company. During
2001, much active trading occurred, pushing the price of the common shares
from less than eight dollars to more than twenty dollars by the end of the year.
Similarly, the trading interest in the preferred shares pushed the dividend yield
from 12% to only 9%.
Shortly after the end of 2001, three other firms made public announcements
about the extent of their holdings in ABL shares. Silverman Mines announced
that they had acquired, on the open market, 32% of the common shares of ABL;
Hislop Industries announced that it had acquired 24% of ABL’s common shares
in a private transaction with an individual who had previously been ABL’s major
shareholder; and Render Resources announced that it had accumulated a total of
58% of ABL’s preferred shares.
However, Silverman Mines and Hislop Industries are related. The Patterson
Power Corporation owns 72% of the voting shares of Hislop Mines and 38% of
the voting shares of Silverman Mines. There are no other large holdings of stock
of either Silverman or Hislop. Render Resources is not related to Silverman,
Hislop, or Patterson.

Required:
a. Has a business combination occurred in 2001, with respect to ABL, as the
term “business combination” is used in the context of the CICA Handbook
recommendations? Explain fully.
 b. What implications do the various accumulations of ABL shares have for the
financial reporting (for 2001 and following years) for:
1. Silverman Mines
2. Hislop Industries
3. Render Resources
4. Patterson Power Corporation

Case 3-4
Pool Inc. and Spartin Ltd.
Pool Inc. and Spartin Ltd. are both public companies incorporated under the
Canada Business Corporations Act. The common shares of Pool have been selling
Business
in a range of $30 to $43 per share over the past year, with recent prices in the area
of $33. Spartin’s common shares have been selling at between $18 and $23; Combinations

recently the price has been hovering around $20.

117
The two companies are in related lines of business. In view of the increasing
exposure of the companies to world competition arising from the reduction in
tariff barriers, the boards of directors have approved an agreement in principle to
combine the two businesses. The boards have also agreed that the combination
should take the form of a share exchange, with one share of Pool equivalent to
two shares of Spartin in the exchange.
The manner of executing the combination has not yet been decided. Three
possibilities are under consideration:
1. Pool could issue one new share in exchange for two of Spartin’s shares.
2. Spartin could issue two new shares in exchange for each of Pool’s shares.
3. A new corporation could be formed, PS Enterprise Inc., which would issue
one share in exchange for each share of Spartin and two shares in exchange
for each share of Pool.

The directors are uncertain as to the accounting implications of the three

alternatives. They believe that the fair values of the assets and liabilities of both
companies are approximately equal to their book values. They have asked you to
prepare a report in which you explain how the accounting results would differ
under the three share exchange alternatives. They have provided you with the
condensed balance sheets of both companies. Pool Inc. presently has 1,600,000
common shares outstanding, and Spartin Ltd. has 1,200,000 shares outstanding.

Required:
Prepare the report requested by the boards of directors.
 Condensed Balance Sheets
Pool Inc. Spartin Ltd.
Current assets $ 7,000,000 $ 4,500,000
Capital assets ~63,000,000 ~22,500,000
$70,000,000 $27,000,000
Current liabilities $ 6,000,000 $ 1,500,000
Long-term debt 14,000,000 5,500,000
Common shares 17,000,000 16,000,000
Retained earnings ~33,000,000 ~~4,000,000
$70,000,000 $27,000,000

Chapter
Case 3-5
Three
Growth Inc.
118 Growth Inc. has just acquired control of Minor Ltd. by buying 100% of Minor’s
outstanding shares for $6,500,000 cash. The condensed balance sheet for Minor
on the date of acquisition is shown below.
Growth is a public company. Currently, it has two bank covenants. The first
requires Growth to maintain a specific debt-to-equity ratio and the second
requires a specific current ratio. If these covenants are violated, the bank loan will
be payable on demand. Growth is in a very competitive business. To encourage
its employees to stay, it has adopted a new business plan. This plan provides man-
agers a bonus based on a percentage of net income.
The president of Growth Inc., Teresa, has hired you, CA, to assist her with
the accounting for Minor.
In order to account for the acquisition, Growth’s management has had all of
Minor’s capital assets appraised by two separate, independent engineering con-
sultants. One consultant appraised the capital assets at $7,800,000 in their pres-
ent state. The other consultant arrived at a lower figure of $7,100,000, based on
the assumption that imminent technological changes would soon decrease the
value-in-use of Minor’s capital assets by about 10%.
The asset amount for the leased building is the discounted present value of
the remaining lease payments on a warehouse that Minor leased to Growth Inc.
five years ago. The lease is noncancellable and title to the building will transfer to
Growth at the end of the lease term. The lease has fifteen years yet to run, and
the annual lease payments are $500,000 per year. The interest rate implicit in the
lease was 9%.
Minor’s debentures are thinly traded on the open market. Recent sales have
indicated that these bonds are currently yielding about 14%. The bonds mature
in 10 years.
The future income tax balance is the accumulated balance of CCA/deprecia-
tion temporary differences. The management of Minor sees no likelihood of the
balance being reduced in the foreseeable future, because projected capital expen-
ditures will enter the CCA classes in amounts that will more than offset the
amount of depreciation for the older assets.
The book value of Minor’s inventory appears to approximate replacement
cost. However, an overstock of some items of finished goods may require tempo-
rary price reductions of about 10% in order to reduce inventory to more man-
ageable levels.
Required:
Provide a report for Teresa outlining how the assets of Minor Ltd. should be val-
ued for purposes of preparing consolidated financial statements. She wants you
to identify alternatives and support your decision.
Minor Ltd.
Condensed Balance Sheet

Cash $ 200,000
Accounts receivable 770,000
Inventories 1,000,000
Capital assets (net) 5,000,000
Leased building ~~4,030,000
$11,000,000 Business
Accounts payable $ 300,000 Combinations
8% debentures payable 7,000,000
Future income taxes 700,000 119
Common shares 1,000,000
Retained earnings ~~2,000,000
$11,000,000

Case 3-6
Greymac Credit Corp.
Greymac Credit Corporation purchased 54% of the shares of Crown Trust Co.
from Canwest Capital Corporation at $62 per share. Greymac Credit was a pri-
vate investment company controlled by Leonard Rosenberg, a Toronto mortgage
broker. Greymac also negotiated a purchase of another 32% of Crown Trust
shares from BNA Realty Ltd. at a somewhat lower price. BNA Realty had pur-
chased its block of Crown Trust shares only a few weeks earlier, but BNA’s own-
ership was being challenged by the Ontario Securities Commission because “the
regulators had alleged that Mr. Burnett [who controlled BNA Realty] was unfit
to hold what amounted to veto control over the affairs of Crown.” The two pur-
chases of blocks of Crown Trust shares, in addition to other shares already held
by Greymac, gave Greymac 97% of the shares of Crown Trust. Greymac was
expected to make an offer for the remaining minority shares.
A little earlier in the same year, Greymac Credit Corporation had arranged a
deal to purchase most of Cadillac Fairview Corporation’s Toronto-area apartment
buildings. The purchase involved some 10,931 apartments in 68 buildings, and
was in line with Cadillac-Fairview’s intention of leaving the residential housing
market.

Required:
a. Had business combinations occurred with respect to Greymac’s purchase of
(1) the Crown Trust shares and (2) the Cadillac-Fairview apartments?
b. How could the OSC view a 32% minority interest as having “veto control”?
 Case 3-7
Sudair Ltd.
On February 7, 2001, Sudair Ltd. and Albertair Ltd. jointly announced a merger
of the two regional airlines. Sudair had assets totalling $500 million and had
1,000,000 common shares outstanding. Albertair had assets amounting to
$400 million and 600,000 shares outstanding. Under the terms of the merger,
Sudair will issue two new Sudair shares for each share of Albertair outstanding.
The two companies will then merge their administrative and operating structures
and will coordinate their routes and schedules to improve interchange between
the two lines and to enable the combined fleet of nine jet aircraft to be more effi-
ciently used. Both companies are publicly owned.

Chapter
Required:
Three
How should the merger of Sudair and Albertair be reported?

120

Problems
P3-1
Company L and Company E have reached agreement in principle to combine
their operations. However, the boards of directors are undecided as to the best
way to accomplish the combination. Several alternatives are under consideration:
1. L acquires the net assets of E (including the liabilities) for $1,000,000 cash.
2. L acquires all of the assets of E (but not the liabilities) for $1,400,000 cash.
3. L acquires the net assets of E by issuing 60,000 shares in L, valued at
$1,000,000.
4. L acquires all of the shares of E by exchanging them for 60,000 newly issued
shares in L.

The current, condensed balance sheets of L and of E are shown below. Prior
to the combination, L has 240,000 shares outstanding and E has 30,000 shares
outstanding.

Required:

a. In a comparative, columnar format, show how the consolidated balance sheet

of L would appear immediately after the combination under each of the four
alternatives using the purchase method.
b. For each of the four alternatives, briefly state who owns the shares of each cor-
poration and whether L and E are related companies.
 Condensed Balance Sheets
(thousands of dollars)
L Co. E Co.
Balance Fair Balance Fair
sheet values sheet values
Current assets $ 4,000 $ 4,000 $ 300 $300
Capital assets 6,000 8,000 400 700
Investments ~~~~`— — ~~`300 200
$10,000 $1,000
Current liabilities $ 2,000 3,000 100 100
Long-term liabilities 3,000 3,000 400 300
Future income taxes 1,000 1,000 100 —
Common shares 1,000 10,000 200 900 Business

Retained earnings ~~3,000 ~~`200 Combinations

$10,000 $1,000
121

P3-2
North Ltd. acquired 100% of the voting shares of South Ltd. In exchange, North
Ltd. issued 50,000 common shares, with a market value of $10 per share to the
common shareholders of South Ltd. Both companies have a December 31 year-
end, and this transaction occurred on December 31, 2001. The outstanding pre-
ferred shares of South Ltd. did not change hands. The call price of the South Ltd.
preferred shares is equal to their book value.
Following are the balance sheets of the two companies at December 31, 2001,
before the transactions took place:
Balance Sheets
As at December 31, 2001
North Ltd. South Ltd.
Book Fair Book Fair
value value value value
Current assets $ 150,000 $200,000 $210,000 $260,000
Capital assets, net 950,000 820,000 780,000 860,000
Goodwill ````110,000 —
Total $1,210,000 $990,000
Current liabilities $ 100,000 $ 90,000 $165,000 185,000
Long-term liabilities 500,000 520,000 200,000 230,000
Preferred shares — 270,000 270,000
Common shares 300,000 100,000
Retained earnings ````310,000 ``255,000
Total $1,210,000 $990,000

Required:
Prepare the consolidated balance sheet for the date of acquisition, December 31,
2001, under each of the following methods:
a. Pooling of interests
 b. Purchase
c. New entity
[CGA–Canada, adapted]

P3-3
On December 31, 2001, the balance sheets of the Bee Company and the See
Company are as follows:
Bee Company See Company
Cash $ 400,000 $ 700,000
Accounts receivable 1,600,000 1,800,000
Chapter
Inventories 1,000,000 500,000
Three Plant and equipment (net) ~3,500,000 ~5,000,000

122 Total assets $6,500,000 $8,000,000

Current liabilities $ 600,000 $ 300,000
Long-term liabilities 900,000 600,000
Common shares 2,500,000 1,000,000
Retained earnings ~2,500,000 ~6,100,000
Total equities $6,500,000 $8,000,000

Bee Company has 100,000 common shares outstanding, and See Company
has 45,000 shares outstanding. On January 1, 2001, Bee Company issues an
additional 90,000 common shares to See Company at $90 per share in return for
all of the assets and liabilities of that company. See Company distributes Bee
Company’s common shares to its shareholders in return for their outstanding
common shares, and ceases to exist as a separate legal entity. At the time of this
transaction the cash, accounts receivable, inventories, and current liabilities of
both companies have fair values equal to their carrying values. The plant and
equipment and long-term liabilities have fair values as follows:
Bee Company See Company
Plant and equipment (net) $3,900,000 $5,300,000
Long-term liabilities 600,000 500,000

The plant and equipment of both companies has a remaining useful life of
nine years on December 31, 2001, and the long-term liabilities of both compa-
nies mature on December 31, 2001. Goodwill, if any, is to be amortized over 20
years.
For the year ending December 31, 2001, Bee Company, as a separate com-
pany, has a net income of $980,000. The corresponding figure for See Company
is $720,000.

Required:
Assume that this business combination is to be accounted for by the purchase
method of accounting for business combinations. Prepare the balance sheet at
January 1, 2002, for Bee Company after the purchase.
[SMA, adapted]
P3-4
On December 31, 2001, Retail Ltd. purchased 100% of the outstanding shares
of Supply Corporation by issuing Retail Ltd. shares worth $960,000 at current
market prices. Supply Corporation was a supplier of merchandise to Retail Ltd.;
Retail had purchased over 80% of Supply’s total output in 2001. Supply had
experienced declining profitability for many years, and in 1999 began experienc-
ing losses. By December 31, 2001, Supply had accumulated tax-loss carry-for-
wards amounting to $280,000. In contrast, Retail Ltd. was quite profitable, and
analysts predicted that Retail’s positioning in the retail market was well suited to
weather economic downturns without undue deterioration in profit levels.
The balance sheet for Supply Corporation at the date of acquisition is shown
below, together with estimates of the fair values of Supply’s recorded assets and
liabilities. In addition, Supply held exclusive Canadian rights to certain Swedish
Business
production processes; the fair value of these rights was estimated to be $200,000.
Combinations

Required: 123
Explain what values should be assigned to Supply Corporation’s assets and liabil-
ities when Retail Ltd. prepares its consolidated financial statements (including
goodwill, if any).
Supply Corporation
Balance Sheet Fair
December 31, 2001 values
Current assets:
Cash $ 20,000 $ 20,000
Accounts receivable (net) 40,000 40,000
Inventories ```210,000 200,000
$ 270,000
Plant, property, and equipment:
Buildings $ 600,000 500,000
Machinery and equipment 500,000 370,000
Accumulated depreciation ``(450,000)
$ 650,000
Land ```200,000 360,000
850,000
Investments in shares ````100,000 110,000
Total assets $1,220,000
Current liabilities:
Accounts payable $ 60,000 60,000
Unearned revenue 170,000 150,000
Current portion of long-term debt ```100,000 100,000
$ 330,000
Bonds payable 400,000 380,000
Shareholders’ equity:
Common shares $ 150,000
Retained earnings ```340,000
````490,000
Total liabilities and shareholders’ equity $1,220,000
 P3-5
Askill Corporation (Askill), a corporation continued under the Canada Business
Corporations Act, has concluded negotiations with Basket Corporation (Basket)
for the purchase of all of Basket’s assets at fair market value, effective January 1,
2001. An examination at that date by independent experts disclosed that the fair
market value of Basket’s inventories was $150,000; the fair market value of its
machinery and equipment was $160,000. The original cost of the machinery and
equipment was $140,000 and its undepreciated capital cost for tax purposes at
December 31, 2000, was $110,000. It was determined that accounts receivable
were fairly valued at book value.
Basket held 1,000 common shares of Askill and the fair market value of these
shares was $62,000. This value corresponds to the value of Askill’s common
shares in the open market and is deemed to hold for transactions involving a sub-
Chapter
stantially large number of shares.
Three The purchase agreement provides that the total purchase price of all assets will
be $490,000, payable as follows:
124
1. The current liabilities of Basket would be assumed at their book value.
2. The Basket debenture debt would be settled at its current value in a form
acceptable to Basket debenture holders.
3. Askill shares held by Basket and acquired by Askill as a result of the transac-
tion would be subsequently returned to Basket at fair market value as part of
the consideration.
4. Askill holds 1,000 shares of Basket and these would be returned to Basket.
The value to be ascribed to these shares is 1/10 of the difference between the
total purchase price of all assets stated above ($490,000) less the current value
of its liabilities.
5. The balance of the purchase consideration is to be entirely in Askill common
shares, except for a possible fractional share element that would be paid in
cash.

The Basket debenture holders, who are neither shareholders of Askill nor
Basket, have agreed to accept face value of newly issued Askill bonds equal to the
current value of the Basket bonds. The Basket debentures are currently yielding
10%. The Askill bonds carry a 10% coupon and trade at par.
Basket, upon conclusion of the agreement, would be wound up. The balance
sheets of both corporations, as at the date of implementation of the purchase
agreement (January 1, 2001), are as follows:
 Askill Corp. Basket Corp.
Cash $ 100,000 $ —
Accounts receivable 288,000 112,000
Inventories at cost 250,000 124,000
Investment in Basket (1,000 shares) 20,000 —
Investment in Askill (1,000 shares) — 40,000
Machinery and equipment—net ````412,000 ``100,000
Total assets $1,070,000 $376,000
Current liabilities $ 60,000 $ 35,000
7% debentures due Dec. 31, 2005 (Note 1) — 100,000
10% bonds due Dec. 31, 2005 (Note 1) 500,000 —
Premium on bonds 20,000 —
Business
Capital–common shares (Note 2) 200,000 100,000
Retained earnings ````290,000 ``141,000 Combinations

Total liabilities and shareholders’ equity $1,070,000 $376,000 125

Note 1—Interest is paid annually.
Note 2—Each company has issued 10,000 shares.
Both corporations have fiscal years that are identical to the calendar year.

Required:

a. Prepare Askill’s pro-forma balance sheet at January 1, 2001.

b. Draft a note to the 2001 Askill financial statements disclosing the purchase of
Basket’s net assets.
[CICA, adapted]

P3-6
Par Ltd. purchased 100% of the voting shares of Sub Ltd. for $1,400,000 on
October 1, 2001. The balance sheet of Sub Ltd. at that date was:
Sub Ltd.
Balance Sheet
October 1, 2001
Net book Fair market
value value
Cash $ 300,000 $300,000
Receivables 410,000 370,000
Inventory 560,000 750,000
Capital assets, net ``1,220,000 920,000
$2,490,000
Current liabilities $ 340,000 370,000
Preferred shares (Note 1) 800,000
Common shares 400,000
Retained earnings ````950,000
$2,490,000
 Note 1:
The preferred shares are cumulative, pay dividends of $4 per year ($1 per quar-
ter at the end of each calendar quarter) and have a call (redemption) premium of
$1 per share. There are 100,000 preferred shares outstanding and they are non-
participating.

Required:
Prepare the eliminating entry(ies) required at the date of acquisition that would be
necessary to consolidate the financial statements of Sub Ltd. with those of Par Ltd.
[CGA–Canada, adapted]

Chapter
P3-7
Three On December 31, 2001, Prager Limited acquired 100% of the outstanding vot-
ing shares of Sabre Limited for $2 million in cash; 75% of the cash was obtained
126 by issuing a five-year note payable. The balance sheets of Prager and Sabre and
the fair values of Sabre’s identifiable assets and liabilities immediately before the
acquisition transaction were as follows:
Sabre Limited
Prager
Limited Book value Fair value
Assets:
Cash $ 800,000 $ 100,000 $ 100,000
Accounts receivable 500,000 300,000 300,000
Inventory 600,000 600,000 662,500
Land 900,000 800,000 900,000
Buildings and equipment 6,000,000 1,400,000 1,200,000
Accumulated depreciation (2,950,000) (400,000)
Patents ```````````— ````200,000 150,000
$5,850,000 $3,000,000
Liabilities and shareholders’ equity:
Accounts payable $1,000,000 $ 500,000 500,000
Long-term debt 2,000,000 1,000,000 900,000
Common shares 1,500,000 950,000
Retained earnings ``1,350,000 ````550,000
$5,850,000 $3,000,000

Required:
Prepare the consolidated balance sheet for Prager Limited immediately following
the acquisition of Sabre Limited.
[SMA, adapted]

P3-8
On January 4, 2001, Practical Corp. acquired 100% of the outstanding common
shares of Silly Inc. by a share-for-share exchange of its own shares valued at
$1,000,000. The balance sheets of both companies just prior to the share
exchange are shown below. Silly has patents that are not shown on the balance
sheet, but that have an estimated fair value of $200,000 and an estimated remain-
ing productive life of four years. Silly’s buildings and equipment have an esti-
mated fair value that is $300,000 in excess of book value, and the deferred
charges are assumed to have a fair value of zero. Silly’s building and equipment
are being depreciated on the straight-line basis and have a remaining useful life of
10 years. The deferred charges are being amortized over the following three years.
Balance Sheets
December 31, 2001
Practical Silly
Cash $ 110,000 $ 85,000
Accounts and other receivables 140,000 80,000
Inventories 110,000 55,000
Buildings and equipment 1,500,000 800,000 Business

Accumulated depreciation (700,000) (400,000) Combinations

Deferred charges ```````````— ``120,000
127
$1,160,000 $740,000
Accounts and other payables $ 200,000 $100,000
Bonds payable — 200,000
Future income taxes 60,000 40,000
Common shares* 600,000 150,000
Retained earnings ````300,000 ``250,000
$1,160,000 $740,000
*Practical = 300,000 shares; Silly = 150,000 shares.

Required:
Prepare a consolidated balance sheet for Practical Corp., immediately following
the share exchange.